|Turned up to eleven: Fair and Balanced|
Friday, March 01, 2002
The Motley Fool was a favorite, till they started to charge for everything), and watching CNBC. After a while, I came to realize that there is a great big game going on here, that has very little to do with measurable ideas of how a given company is doing.
I want to focus on just one example of the game, and that is the recent focus on earnings growth. You see, it is not good enough for a company to make a 10% profit every year; the earnings have to grow. They don't necessarily have to grow as a percentage of revenue, but they have to increase over time. Because it is often easier to think in terms of relatively small percentages (0-100%) as opposed to large numbers (1,000,000-1,000,000,000), the comparisons invariably start to be percentages. This is where a huge, and largely unacknowledged, problem lurks. Percentage growth is an exponential, rather than linear process. To understand this, think about the interest you pay on your mortgage, or your credit cards. What this means is that the demand for 10% growth becomes ever harder to fulfill. Suppose you run a company, and you make 100 dollars this year. Next year, in order to justify your stock price, you need to make 110. The year after, you need to make 121, and the year after, 133.1, just to maintain the same stock price (or p/e ratio) This game will be fine as long as the difference between linear and exponential growth is small (as it is in the above example), but just five more years down the road, a company with linear earnings growth would be earning 180 dollars, while the 10% per year (compounded) growth would be $214, a 15% difference.
This disparity only gets worse. So the company is faced with two choices; raise prices, or produce more. The supply demand curve more or less dictates how well this will work out, and there isn' t much room for exponential growth there. So, inevitably, the companies start feeling an intense pressure to get profits up, any way they can. This comes largely from listening to their shareholders, something they are obliged to do (and should be). Even worse, at some point, expectations get raised by the market, to the point where steady growth is insufficient, and fast growth is the only way to keep the stock price up. Add into that the seduction of stock option billions, and you got yourself a bubble, son.
So where does Enron fit in? Simple. At some point, no amount of fast talking can keep the stock price up. "Someone has to pay for all of that growth, but it's not gonna be us," said Skilling, Fastow and Co. "Higher profits, higher profits" shouted the mavens of Wall Street. "Buy, buy, buy" cried the penguins (analysts). The cycle pushed the price higher, on promises of fast, easy money, and then the board room boys had to figure out how to deliver. It is just not that hard to see how they might have come up with this scheme, in the bubble bonanza of 1999. "Don't worry, no one will ever figure out this balance sheet," says Fastow. In the words of Andrew Lloyd Weber "When the money keeps pouring in, you don't ask how" (from Evita, not my favorite, but appropriate, no?). Does this mean that the Enron boys shouldn't be punished? Of course not. Does it mean the Bushies weren't involved? Again, who knows. It certainly looks a bit fishy, but that is what investigations are for. But lets not forget that anyone who bought stock in the late '90s with the hopes of becoming an instant millionaire has a bit to think about now.