Reviewing RIM's Dismal Earnings Report, Low P/E Ratios, and the Damage Done

By Michael Comeau A look at Research in Motion's headline numbers and a lesson in the dangers of buying stocks based upon low P/E ratios. Yesterday (June 16) after the close, Research in Motion (RIMM) delivered yet another dismal earnings report, continuing one of the most clearly telegraphed implosions in tech-stock history. (To read Joe Jordan's article on the potential of the marijuana market, click here.) Let's go through the headline numbers before we head to today's lesson in the dangers of buying stocks based upon low P/E ratios: 1. In the first quarter, RIM earned $1.33 a share on $4.9 billion in revenue, numbers that failed to match the forecast offered on April 28 when the company cut guidance. 2. The company shipped 13.2 million Blackberry units, also missing guidance. 3. For the second quarter, the company now expects earnings of $0.75 to $1.05 a share on $4.2 to 4.8 billion in revenue, an unusually wide range that is well-below Wall Street's current forecast. 4. Full-year earnings guidance is now hanging at a range of $5.25 to $6 a share, way down from the company's prior $7.50 forecast. That range is also deep below Wall Street's $6.29 consensus number. 5. If you were holding RIM after the close yesterday, you're down another 15%. 6. If you work for the company, you might find yourself out of a job very soon as the company also has layoffs “to streamline operations.” On May 20 in my article Salesforce.com Provides Lesson on Dangers of Shorting High-Octane Momentum Stocks, I highlighted Salesforce.com's (CRM) big rally after reporting stellar first-quarter numbers as an example of why you shouldn't short high-octane momentum stocks based upon "high" P/E ratios. (To read Todd Harrison's thoughts on the financial crisis and the stages of grief, click here.) RIM's latest dive is reinforcing the contrary lesson -- that it makes no sense to buy super-cheap stocks simply because they're super cheap. As I said in my opening statement, RIM's implosion has been clearly telegraphed. The company's consistently weak earnings reports, uninspired product launches, and market-share losses to Apple's (AAPL) iPhone and Google's (GOOG) Android operating system have painted a dire picture for years now. Thus, there has been no reasonable case to be made for buying RIM based upon some new-found energy in the company's business, at least not recently. The Playbook is doing surprisingly decent volume, but that's not enough to offset weakness in the core BlackBerry unit. No, all recent bull cases on RIM have been largely based around valuation arguments -- the good old “it's cheap so it has to go up” mentality. The Lesson Learned Let's do some math. Heading into yesterday's close, the full-year consensus earnings forecast for RIM was $6.29 a share. That means the stock was trading at less than six times expected earnings. And forget about comparing RIM to companies like Apple and Google - it was cheaper than General Motors (GM) and US Steel (X). (To read Todd Harrison's piece on what Europe means for you, click here.) However, 6 times earnings isn't very cheap when earnings guidance gets slashed to a range whose midpoint is: 1. 11% below Wall Street's expectations, and 2. 25% below company guidance issued less than two months ago. Putting the Lesson Into Practice When looking at stocks going forward, try to resist the temptation to look at a P/E ratio in isolation. A P/E ratio means absolutely nothing without considering the direction of earnings momentum. If the E in a stock's P/E is shrinking, then you're looking at something that isn't as cheap as it appears. The opposite is also true. When that E keeps getting bigger, you're probably looking at a stock that isn't as pricey as it first appears. So if you really think about it, heading into their respective quarterly earnings reports, Salesforce.com was cheaper at 107 times earnings than RIM was at 6 times earnings! Why? It's all about the earnings momentum. Salesforce.com is beating expectations and guiding up, and that means its momentum is going in the right direction. That breeds confidence, which in turn drives an expanding valuation. And a Confession I'm not trying to sound like an all-knowing stock-market genius here. The reality is that I've lost plenty of money over the years by going after broken growth stocks that were "cheap." I've also completely blown it for my readers quite a few times over the years by taking simplistic views of valuation measures and failing to see the big picture of earnings momentum. To read the rest, head on over to Minyanville.