There's a misconception within the investment community that public companies give Wall Street analysts more precise earnings guidance than they give the average investor. This is simply not the case. Analysts generate their models by using the mosaic theory. They essentially piece together bits of information and weigh the probabilities to come up with an earnings number and get a feel for where the company is headed.

Individual investors can do this too if they know what to look for and what information to gather. In this article we'll explore what kind of information you can look at to put the pieces of the puzzle together for yourself. (The first step is knowing where to get the information you need. To learn where to go, check out The Flow Of Company Information.)

Margins
Individual investors need to get a handle on a company's gross and operating margins because, frankly, they provide the best clue as to where earnings are headed. In order to do this investors should first examine the company's latest quarterly earnings filing (form 10-Q) on the SEC website. This will allow you to see where the margins have been over the last few quarters and if management has made any comments on where margins are headed. This information can be found in the Management Discussion and Analysis (MD&A) section. In short, this will give the individual investor a baseline to work with.

Next, it's time to see what's going on in the current quarter. Try to answer these questions:

  • Has management made any mid-quarter comments on pricing?
  • Have competitors hinted about pricing pressures?
  • Is the company heavily discounting its products through the use of coupons?

These bits of information will provide hints as to whether things are tracking according to managements plan or if perhaps margins are on the decline. (For more, see The Bottom Line On Margins.)

It's hard to divine an exact number with just this little bit of information; however, one can look back at historical quarters and see the typical variance in margins over time as well as factor in management's prior guidance if any. By doing this the investor will have a better feel for exactly how low the margins might go.

Keep An Eye On New Products
Very often in the MD&A section or during a conference call, management will make comments about up-and-coming products. The comments are fairly general, but they will usually include expected sales and launch dates that can give you a starting point. Investors should take note when comments like these come out because extrapolations can be made to determine the potential impact on the bottom line in the current year.

Example - New Product Announcement
You comb through the latest MD&A section and find this hidden gem from WidgetCo.
"We plan to launch our new TurboWidget on February 1 and to do $100 million in annualized sales."
From this we know that the company probably won\'t do $100 million during the current calendar year. Rather, it\'s planning on generating $100 million shares from February to February (its fiscal year). The amount generated in this calendar year will probably be around $91.7 million. Here\'s how that works:
$100 million / 12 = $8.33 million in revenue per month
$8.33 million x 11 months (Feb-Dec) = $91.7 million.
(Note: This is an approximation because it takes time to ramp up sales.)
Taking this one step further, if we know that the company usually generates a 10% net margin on its products, then we know that $9.17 million will probably fall right to the bottom line in this calendar year. And if we know that, it\'s easy to divide that amount over the number of outstanding shares and figure out the earnings-per-share contribution the product could make.

To be clear, this is not an exact science, and because things change constantly, analysts must constantly tinker with their models. However, investors can and should be using this same thought process to help them in their investment decision making.

Look For Possible Problems
Has management said that the company has some obsolete inventory on the books that the company needs to write off? Or are they planning on exiting a particular business? If so, they will usually provide estimates of any planned charges to earnings in a press release, conference call or in the MD&A section.

But even if the company doesn't provide an estimate, sometimes the investor can determine how much will be written off by other comments that management makes.

Example - Do It Yourself Write-Off Calculation

Let\'s imagine that during a conference call a CFO said:
"We are going to write off our entire inventory of baseball gloves."

From this, the investor can then look at the description of inventory in the latest quarterly filings and then determine what percentage of the total inventory is composed of baseball gloves. If it\'s 2% things might not be too bad, but if it\'s 20% - watch out. In short, this will give the investor a clue as to how big of a hit the company may take in the upcoming quarter. (To find out more, see Read This Before You Sell.)

New Distribution Channels
Sometimes a company has great products and must simply build out new distribution channels to succeed. If this is the case, try to determine if a product or service would be a good fit for a major store or channel. Often, you can make a suggestion for bettering the product distribution right at a conference call meeting. You'd be surprised how candid management can be.

Another option is perusing analyst reports (available to clients of the brokerage) or checking out the MD&A section. There is a lot of information out there once you start looking. (To learn what information and input you're entitled to, see Knowing Your Rights As A Shareholder.)

Even if you get the answers you are looking for, it's important to remember that this is far from an exact science. For example, even if a major retailer agrees to carry a company's product it's usually on a test-basis first. It will then expand distribution based upon demand. Also, in order to get into a large distributor, the vendor must often reduce its selling price dramatically. However, information on potential new distribution channels can still help individual investors determine if the company has a chance of beating the current consensus estimate on the Street. (To learn more, see Can Earnings Guidance Accurately Predict The Future?)

What's The Competition Doing?
Many investors look at companies as if they existed in a vacuum. Instead, they should be weighing what could happen if new competition has emerged or exited the business. If, for example, WidgetCo had been dominating the market, but suddenly WidgetTech is coming out with a better product, it's possible that the earnings estimates for the WidgetCo could be in jeopardy.

Here's how analysts would put an estimate on the impact to WidgetCo's earnings:

  • First, analysts determine how big the market potential for a new widget product is through extensive research, and then determine how long they think it will take to fully tap that market.
  • Then, they make estimates to determine what percentage of the market each widget maker can capture.
  • Finally, they back themselves into an approximation of the potential impact to earnings.

This is probably beyond the average investor's range of expertise and ability. However, individuals can still take note of new products in the market, and attempt to determine if they'll hurt a particular company's sales or earnings or if the current consensus estimate for that company might be too aggressive. (For related reading, see Competitive Advantage Counts and The Advantages Of Investing In Aggressive Companies.)

Find Similarities or Benchmarks
Whether analyzing the potential for a new product or a company's overall earnings potential, try to find another company in a similar situation and then extrapolate accordingly.

Example - Using Benchmarks
Let\'s say drug company Pfizer (NYSE:PFE) came out with a product that reverses male pattern baldness and the drug generated $100 million in sales during its first year in the business. Then a small pharmaceutical company with a smaller sales reach and fewer distribution outlets comes out with a similar product (whose efficacy is similar); it\'s pretty safe to say that the small company won\'t be able to generate $100 million in sales its first year. So, investors should be skeptical of analysts or companies who say it could.
Conversely, if Merck (NYSE:MRK) and Johnson & Johnson (NYSE:JNJ), two drug companies of similar size to Pfizer, were to develop and co-promote a similar product (and they had twice the distribution network that Pfizer had), you may be able to estimate they could indeed generate as much as twice the amount of sales in the first year.

Of course, this example is an oversimplification. Some doctors will be reluctant to recommend new drugs, and Pfizer might already be developing a stranglehold on the business, for example. But for simplicity purposes this is how it's done. Again, the objective is to get a frame of reference and then to make as accurate of an estimate as possible.

Are Cost Savings Possible?
Next look at what the company is doing to save money and what it could do in the future. Is it about to lay off 100 workers, or is it going to close a particular facility? If so, keep in mind that there could be some upfront severance or plant closure costs that could affect the current quarter. However, also keep in mind that this will also probably save the company a good deal of money going forward.

If the company doesn't give a hint as to what type of employees it will be letting go (upper management, middle-management, assembly-line workers, etc.), you can make an assumption that the average employee makes around $50,000 a year and then piece together a basic cost savings estimate. Similarly, if a company is about to get rid of a building, one can assume that it won't have to pay taxes or do maintenance on the facility going forward.

The Bottom Line
Analysts use the mosaic theory to piece together information about a company and then make assumptions about that company's earnings going forward. The good news is that savvy investors who are willing to do a little footwork on their own can do the same thing.

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