Microsoft and Yahoo: the ten-year search agreement

Two days ago MSFT and YHOO announced an agreement to pool their web search resources for ten years.  In general terms, MSFT will provide the search technology through its Bing search engine, YHOO will sell the service to potential advertisers.  At the end of the first five years, the terms of the deal are subject to a reset, but the companies didn’t say by how much or at whose option.

YHOO expects to have extra cash flow of $275 million a year from the deal.  MSFT said little other than it expects to spend several hundred million dollars in the initial years.  Let’s say this means $2.75 billion (around $2 a share) for YHOO and that MSFT breaks even for the decade-long partnership.

Several aspects of the deal and its announcement are worthy of note: Continue reading

Arbitrage Pricing Theory (APT)

In 1976 Stephen Ross published an extremely influential article, titled “The Arbitrage Theory of Capital Asset Pricing,” in the Journal of Economic Theory. His “theory,” which is really more of an hypothesis or suggestion, is offered as an alternative to an earlier academic theory, the Capital Asset Pricing Model.

Investors in Ross’s world are the usual academic stick figures, who all have the same information and expectations.  And he appears as eager as his predecessors to use the tools of statistical regression analysis and computer power to make very precise and complex calculations.

Ross’s innovation

What’s new in Ross’s approach is his starting point, which is investor expectations, rather than price outcomes in the movement of actual securities.   Continue reading

What is an earnings “surprise”?

When the consensus is wrong

The basic idea behind growth stock investing is to find a company where earnings will be growing faster than the consensus expects for longer than the consensus expects.

For instance…

An example:  Let’s assume a stock is trading at $20 a share.  It had earnings of $1/share last year and is expected to grow by 15% each of the next few years.  This means that, on consensus expectations, it is trading on 20x historic earnings, 17.4x this year’s earnings, and 15.1x next year’s earnings.  As a crude rule of thumb, one might say that fair value for a stock is to have the price earnings ratio equal to the growth rate on next year’s earnings.  On that measure, the stock is fairly valued.

Let’s say the true earnings growth rate is 40%.  That would mean that our stock is trading at 14x this year’s earnings and 10x next year’s.  That’s about a quarter of what our rule of thumb would imply. Apple is a recent instance of this phenomenon.

How does the market adjust its expectations upward?   Continue reading