You Want It…You Got It

The earnings announcement of Research in Motion (RIM) last night triggered me to write about something that had been brewing in my mind for some time. RIM missed their earnings by one penny and the stock is trading 25% below yesterdays close.

The market punishes companies for missing guidance as companies like RIM are priced to perfection. This is where the problem lies and I believe has lead to alot of the problems for financial stocks in the US and the rest of the world.

I laughed when I heard that the FBI was going to do an investigation on the executives of the failed financial firms as the whole system is to blame for what has happened and these same executives would have been fired earlier on had they not done what they did.

As a publicly traded company, investors demand results and they compare your results with those in your sector. Revenue growth, earnings growth, and a key measure in the financial sector is something called Return On Equity (ROE).

In the past, financials that had an ROE of 15% were considered operating at exceptional levels. However, investors demanded more of the executives and wanted ever increasing Return on Equity as higher ROE leads to higher stock prices. How does this happen? Well, a good place to start is by increasing the leverage on ones balance sheet. If one company leveraged their balance sheet 10 times, the next would increase theirs to 11 and so on to increase their ROE to numbers that exceeded 25%.

If a firm or its board were so inclined to keep their balance sheet conservative, they could be shunned by investors as their earnings growth and ROE didnt match their competitors leading investors to bail on the stock for greener pastures. The same executives that are being investigated would have been fired along time ago for not matching the results of their peers.

This leads to my thoughts on what changes need to be made. Why should a company in the case of RIM have their stock drop 25% in one day after their year over year sales increase by more than 100% but earnings miss by one cent a share. Companies are forced to perform and make decisions in the short run that are not in the best interest of the company in the long run.

I don’t have a solution yet but would love to hear your thoughts on this topic.

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