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By Brian Nelson, CFA

At Valuentum, we take a different view on stocks than what may be widely held in the investment community. As many play the earnings game--anticipating whether a firm will beat or miss revenue/earnings estimates or guide above or below consensus for forward periods--we, on the other hand, like to view stocks as businesses. Over time, the best businesses will ultimately see the most equity value appreciation, in our opinion, regardless of what analyst expectations are on the stock in any given quarter. After all, should investors really care if a company misses earnings by a penny or two (or more), if the firm's competitive advantages, operational prowess, and earnings growth trajectory are still intact after the report? We tend not to care too much about quarterly earnings, and every day we seek to profit from the market's overreaction to both earnings misses and beats.

At the end of the day, we think valuation is the most important investment consideration. The logic behind the earnings game just doesn't make sense. If a company keeps missing earnings estimates, for example, into perpetuity, will its stock go to $0? Absolutely not. It just means the analysts are being too optimistic relative to what the company can achieve (is it the company's miss or the analyst's miss?). But what if a company keeps beating estimates; will it keep going up forever? It shouldn't. We're disappointed so many mom-and-pop investors get lured into this way of near-term thinking, but it's quite understandable. For one, when market onlookers turn on the news, what they see is that a stock has popped on "better-than-expected" earnings, so it's easy to associate one with the other. But such moves are only temporary (it's mostly traders looking to capitalize on value resets), as stocks will always (and we stress) always migrate toward their intrinsic value.

The problem investors face is that intrinsic value is difficult to measure. And for many, it's not all that fun to do extensive fundamental analysis to uncover investment gems. That's why many investors turn to technical analysis; after all, it's much easier to look at a chart than assess the long-term competitive advantages, growth prospects, and profitability trajectory of a company. We think the intrinsic value of a firm is the sum of the present value of a firm's future free cash flow stream. This makes sense--please just think about this for a second. Why would you pay anything more than what you think you can receive as cash flows discounted by the time value of money? Paying anything more would be ludicrous, right? You'd go broke if you kept handing out more money than you'd think you'd get back. Well, let us tell you, instances like this happen every day in the market. Look at LinkedIn (NYSE:LNKD), Churchill Downs (NASDAQ:CHDN), Chipotle (NYSE:CMG) and Under Armour (NYSE:UA) -- and now Groupon (NASDAQ:GRPN) as examples.

So how do these bubble stories happen? Well, it often comes down to the superficial earnings game that sell-side analysts play--they purposely low-ball their estimates, so their favorite companies can beat them (their jobs are intensely competitive, and they have clients to please). The industry has even had to come up with a "whisper" number due to this low-balling, and even this is unestimable--regardless of what you've heard. The earnings game is then exacerbated because speculators think they can sell overpriced stock at a higher price because 1) they have before and 2) investors haven't yet learned the importance of intrinsic value. Don't be fooled by buying overpriced stock. Think of overpriced stock as a hot potato, and someone will be left burnt once the story unravels.

Ok, so you may say: I'm just a tiny individual investor, how can I view myself as being able to own a piece of a massive company? Well, let's put it this way. When private equity or another firm buys a company you've invested in, you get paid out based on what a firm is willing to pay for the entire entity--not just your shares. So why should you analyze a firm any differently? Ok, so you may say: Not every firm gets bought out. That's true, and we recognize that such an issue may be present with behemoths such as Apple (NASDAQ:AAPL) or Exxon (NYSE:XOM), which may never truly reflect their intrinsic value as very few other entities can afford to buy them (they just have become too big). But for the most part, all firms are essentially in play or will be in time--meaning that if a firm's stock price falls too low relative to its intrinsic value, it will find a way to get taken out or go private. We're not saying that investors should include a buyout premium in every valuation (in fact, we're not saying that at all). But we do think a firm deserves to be valued appropriately based on its own future free cash flow stream.

If you're still reading this, you might be wondering what the best way is to determine a firm's intrinsic value. Well, it all comes down to free cash flow. The measure is not intimidating and simply represents the residual cash left over in the business after capital expenditures. In other words, it is the earnings of a firm +/- working capital changes less capital expenditures. Everyone knows that cash is king, and diluted earnings per share is just a shortcut for those less-skilled in accounting. Don't fall into the trap of taking shortcuts. We use a discounted cash-flow model to calculate an intrinsic value for every firm in our coverage universe (the template can be found here).

And this template has worked wonders for us. We told investors to steer clear of Netflix (NASDAQ:NFLX) here and avoid AMR Corp here--two names that have absolutely been hammered in the past couple months. And on the long side, we uncovered a double in EDAC Tech (NASDAQ:EDAC) and solid gains from a variety of other firms. Give the discounted cash-flow model a try in your own investing arsenal.

And please notice we didn't say dividends. You, as an investor, have a claim on all of the free cash flows of the business (after interest, preferred), not just the dividend stream that is decided by the board of directors. Anyone who uses a dividend discount model should re-evaluate their processes (it only works if dividends equal enterprise free cash flow, free cash flow to the firm). And investors should know that, after a firm pays the dividend, the price of a stock opens lower by approximately the amount of the dividend. That's because cash is leaving the firm and ending up in your hands. That's right, we said cash.

In other words, when a firm pays out a dividend, it is reducing its intrinsic value by the amount of the dividend. That's okay though, since you're getting the cash. We think this concept is vitally important for investors to understand, as it opens the door to understanding equity valuation and is unfortunately not widely known. If it were well known, we wouldn't see so many investors getting so excited about dividend payments (it's a net-neutral action, excluding tax implications). So, by extension, it's not the dividend that necessarily maximizes returns (as some may think), but the ongoing and continuous investment of them in a given company over time. It allows for dollar-cost-averaging and traditionally creates a lower cost basis than one-time purchases, as most investors understandably have trouble timing the market. In fact, we love to capitalize on pullbacks (and reinvest) on some of our best ideas.

All things considered, don't play the earnings game. Focus on intrinsic value with a long-term perspective instead. You'll thank us during retirement.

Source: Is The Earnings Game Worth Playing?

Additional disclosure: Some of the names above may be included in our monthly Best Ideas Newsletter.