“invest in the future, don’t dilute your finances”- Kendrick Lamar
It’s the consensus view on Wall Street that a publicly traded company should beat revenue and earnings expectations. A company’s stock price usually climbs when they do, and falls when they don’t. And it makes sense, of course, in most cases. If a company is growing earn-rev faster than expectations, that bodes well for it’s future. The problem though, is that people start to mistake the means for the end. Wall Street starts thinking the goal is to always beat those estimates, not improve a company’s future value. So when a company makes heavy investments in it’s future, that cuts down their reported earnings (even though this is just an accounting, not economic reality), and then investors dump the stock even though by all likelihood, it’s future value will be enhanced by those investments. That’s exactly what is happening here with Facebook. You have a company with revenues up 64%, beat all expectations and more, but because it wants to increase it’s expenses by 50-70% to invest in future growth by next year, the stock is down 10%. It makes no sense. I wish I hadn’t sold my Facebook stock when I did. Even if I had money now, I wouldn’t buy it again because it is priced high, and there are better opportunities, but make no mistake, this is the right path to follow. This is one advantage private companies have over public ones, and one reason why recent company owners (including Zuckerberg) have tried to maintain voting power even after their IPOs. Let me illustrate how this would work in a private company and why investors have to resist the short term urge to follow the estimates and take the long view.
Say you own a small vegetable garden which you sell produce out of at lower than market rates. In the first year, you sell at 60% of Walmart prices and net a $60,000 profit on a $300,000 revenue (If you were public, investors are happy, stock shoots up to 25 times earnings, so you’re valued at $1,500,000.) The following year, you figure you want to expand your farm, and buy a van so instead of selling only on your porch, you can distribute more food to a wider audience. You plant double your farmland for $90,000, plant extra seeds for $10,000, buy a van for $30,000 and spend an additional $20,000 in labor bringing your total additional expense to $150,000. Your revenue due to the investments will grow 33.3% for three years afterwards, without additional expense. Here’s what your financials will look like in years 1 to 3 after the investment.
Year One Year Two Year Three
Revenue $400,000 533,320 711,076.
Expense ($240,000) ($240,000) ($240,000)
Add. Inv ($150,000) 0 0
Profit $10,000 $ 293,320 $471,046
Now obviously, I have simplified super crazy. But the point is, massive investments early in the growth cycle often boost earnings in the future even if they reduce current profits, which means your business’ future value is increasing. Any owner would gladly take a 50% decline in profits in the first year of massive investments in exchange for the exponential growth down the road. This is exactly the kind of strategy wall street punishes. Because the year before, profits were $20,000 and revenue is growing maybe 20-30%, the earnings estimate would be around $25,000. When instead you post $10,000 in that year, your stock will be killed on the market, despite the fact that you’ve just unlocked future earnings that are over ten times that high which means your stock should be increasing. So much for efficient markets.
In the end, as an investor, this is the reason why the greats advise you to think like an owner. Forget the constant price gyrations and focus on the business value. In fact, it’s better to take the ‘invest in the future’ mantra to absurdity than to give in to Wall Street’s short term thinking. Amazon proves that. I’m not sure they foresaw Alibaba coming to eat the lunch they’ve spent so long carefully cooking, but that’s a story for another day.
Hope you learned something. Let me know what you think in the comments.