NYU Prof, Damodaran, on Price vs. Value: Reading Earnings Reports

NYU finance professor Aswath Damodaran writes in the blog Musings on Markets about “the pricing and value game and how they play out, especially around earnings season.” Contrasting the two concepts, Damodaran says that value “comes from a company’s fundamentals, i.e., its capacity to generate and grow cash flows,” while pricing “is a market process” that results from supply and demand and is “a function of market mood/sentiment and incremental information about the company.” Accordingly, he says that “investing is about judgments on value . . . and trading is about making judgments on future price movements.” Further, he says, earnings reports are particularly important because “revelations about what happened to a company in the most recent three-month period become a basis for reassessments of price and value.” In “the pricing game,” Damodaran asserts, an earnings report is “measured up against expectations,” such that exceeding expectations raises prices while failing to meet them lowers it. He says this “pricing game” is an “unpredictable one for three reasons.” First, the “actual numbers” of earnings reports are a manipulable “mixed bag.” Second, there is the question of whether the relevant “expectations” are those of analysts or the market. Third, “the market reaction to surprise” is unpredictable. Regarding the “value game,” however, Damodaran paints a different picture. He contends that “the one area where there should be agreement across investors is that every good intrinsic valuation should be backed by a narrative that not only provides structure to the numbers in the valuation, but also provides them with credibility.” He continues that “if you accept the notion that value changes when your narrative changes,” there are three points that follow.

#1 – “an earnings report can cause big change in value” because “a key part or parts of the narrative [may have] changed by an earnings report.”

#2 – “big changes are more likely in young companies” and “consequently, you should not be too quick in classifying a big price move on an earnings report as a market overreaction.”

#3 – “there is more to an earnings report than earnings per share,” which means that factors such as “product breakdown, geographical growth or cost patterns” can be very significant.

In summary, Damodaran says that “new earnings reports . . . provide timely reminders that no valuation is timeless and no corporate narrative lasts forever.”