…There is no greater enemy of stock market allocation efficiency than earnings obsession.…2
While Wall Street feeds on its quarterly earnings obsession, the market, which represents the aggregate opinion of all investors, looks beyond this accounting figure and focuses on assessing the economic performance, or actual cash generation, of companies and industries. If this were not the case, the astute analyst who based his investment decisions on cash flow valuation should be able to systematically beat the market. Since the market is notoriously difficult to beat, it seems reasonable to assume that at least some form of market efficiency encompasses economic performance evaluation.
Although the value of a firm should reflect the present value of the firm's future free cash flow,3 analysts often act as if earnings are a reliable, quarterly proxy for current cash flow. Is this sensible? A monochromatic focus on earnings ignores the fact that the earnings number is the result of many accounting assumptions that encompass all the financial statements: Income, balance sheet and cash flow. Earnings are normally very different from economic value and free cash flow. The quickest way to pump up earnings is to cut R&D or marketing expenses. Although earnings would dramatically jump, the market would see through this trick and punish the firm for short-circuiting its future. This is where accounting and economics collide.
While the assessment of economic performance starts ...