Forget Valuation, It's A Numbers Game: Wall Street's Rules, Part 4

NEW YORK (TheStreet) -- I've received quite a bit of criticism over the past couple of weeks for some pretty bold earnings predictions -- some of which were colorfully described by one reader as randomly "throwing (you know what) to the wall to see if it sticks."

It was much more sophisticated than that -- or at least I think so. However, I do realize that sentiment is often derived from the source of an existing bias. In other words, I'm a bum in the minds of those who disagree with my stock picks and a genius to those with whom I agree, regardless of outcome. Nevertheless, making the call is what it's all about.

More Than Just Being Right or Wrong

In the first part of this series, we talked about the importance of making investment decisions more about the bottom line and less about perpetuating the "rules of investing," or the sometimes unspoken myths that qualify your status as an investor but yield little in the way of results.

In the second part, we looked at the myths surrounding portfolio diversification, while the third part reminded us that, on Wall Street, it is true that a sucker is born every minute. In this article, we are going to look at the importance of understanding a company's business and, at times, focusing less on valuation.

The Game of Numbers

I argue that if investors truly understand the underlying business, being "near-term right or wrong" won't matter as much, which proved exactly the case last week.

Nothing on Wall Street is more exciting in my opinion than earnings season. I love this time of year because it reminds me of school. It's called "reporting period" because this is when companies put their records on the line and are issued passing or failing grades.

In a similar fashion, it gives me, as an analyst, an opportunity to make a buy or sell call on the assumption that a report will either be positive, negative or materially inconsequential.

The perfect example is Apple's ( AAPL) disappointing earnings results, which prompted Apple bears and Research in Motion ( RIMM) bulls to start dancing in the streets.

But if truth be told, did one quarter actually change the company's narrative? Not really. Instead, it was a game of numbers where what was expected was disconnected from what the company produced, which was both 20% revenue and earnings-per-share growth.

On that news, the stock dropped as much as 5%. While 20% EPS growth would be cause for celebration at most firms, at Apple, that is just not good enough. But does it mean optimism was the incorrect play?

By contrast, take Facebook ( FB), which has battled both fundamental and valuation concerns. In fact, no other stock on the market today represents "the game of numbers" better than Facebook. Its 955 million users seem to be enough to justify its high trading multiple, which remains more expensive than both Apple and Google ( GOOG).

Upon its disappointing earnings results, the stock has dropped almost 20% even though it delivered somewhat respectable numbers. Admittedly, although we made the correct call ahead of the report, Facebook's numbers were actually much better than I projected.

However, unlike Apple, Facebook (literally) had no business trading at its lofty valuation. If investors had focused on the underlying business, they would have been saved not only from the earnings disappointment, but also from all of the hysteria that surrounded its hype-filled IPO.

Though Facebook demonstrated better-than-expected revenue and active monthly users, it failed to impress investors who have been waiting patiently for the company to prove that it deserves their money. Instead, what the numbers showed was what investors have feared during the past couple of months: that revenue growth has slowed. This happened even though it beat projections.

Investors realized that Facebook's 32% sequential revenue growth was smaller than the 44% it generated in the first-quarter. While not an entirely disappointing number, it does (to some extent) support the notion that the company has yet to solve its user-monetization issue. Although its user base continues to grow, neither its earnings nor its revenue are growing enough to support its valuation. In Facebook's case, it's all in the numbers.

However, that is not so for others. One company in particular -- Amazon ( AMZN) -- continues to prove why valuation does not matter. Bears argue that the stock is expensive, but that has always been the case for Amazon. As perfect as the company must be to maintain its lofty valuation, Amazon continues to execute to perfection.

In terms of reported sales, there aren't many companies of Amazon's size that are producing the level of growth it has demonstrated. As a result the stock is up 35% year to date and more than 170% in the past three years. Clearly, Wall Street cares very little about valuation in this case. Bears that want to continue fighting the Amazon story are doing it at their peril. It's a game of numbers.

Bottom Line

One of an investor's biggest challenges is always assessing the investment-worthiness of stocks that are trading at higher multiples. Not only does it get complicated if one does not already have a standard for what represents "value," but it gets even more problematic if the investor is not yet certain of his or her objectives -- be it growth, income or, for that matter, value.

I enjoy playing the game of picking stocks ahead of earnings by first focusing more on the economics of the company -- its numbers -- and trying to weigh the probability that certain events will or will not transpire. That's because I think that an investor will be more accurate in predicting what will happen to the stock price by placing a focus on the economic aspect of the equation, and not the valuation.

Although value investors such as myself often place a premium on the importance of valuation, in certain situations I've come to understand that is not always the smart approach. Instead, it is more beneficial to look at the underlying business and the numbers that the company must produce to support the growth investors expect.

At the time of publication, the author was long AAPL and held no position in any of the other stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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