Earnings season is one of the most anticipated points during the financial year for the market. It refers to the months when quarterly reports are released—generally in January, April, July, and October. And with the hype of the season come analyst expectations.
Analysts use forecasting models, guidance, and other fundamentals in order to come up with an earnings per share (EPS) estimate. The market uses these estimates to determine how a company will perform when the earnings are released.
For better or for worse, companies are judged by their ability to beat market expectations—all eyes are on whether companies "hit their numbers." In other words, they're judged on whether they manage to match Wall Street analysts' consensus estimates. Knowing the importance of those estimates can help investors manage through quarterly earnings results.
But keep in mind, these are estimates, so they may never be consistent from one analyst to another. That's because one analyst may use different metrics to come up with his estimates compared to others. So while your investment decisions shouldn't be weighted too heavily on whether companies meet, miss, or beat forecasts, it is worth keeping an eye on how their earnings figures stack up against quarterly estimates.
Read on to learn some tips for survival as you wade through analyst expectations and estimates during earnings season.
Watch Those Estimates
A company's ability to hit earnings estimates is important to the price of its stock. If a company exceeds expectations, it's usually rewarded with a jump in its share price. If a company falls short of expectations, or even if it just meets expectations, the stock price can take a beating.
Beating earnings estimates says something about a stock's general well-being. A company that routinely exceeds expectations quarter-after-quarter is probably doing something right. Consider the performance of Cisco Systems in the 1990s. For 43 quarters in a row, the internet equipment player beat Wall Street's expectations for higher earnings. All the while, its share price saw a huge increase between 1990 and 2000. As a general rule, companies with predictable earnings are easier to assess and are often better investments. (For more reading, see Earnings Forecasts: A Primer and Earnings Guidance: Can It Predict the Future?)
Conversely, a company that consistently falls short of estimates for several consecutive quarters likely has problems. One example is Lucent Technologies. Between 2000 and 2001, the technology giant repeatedly missed earnings estimates—in many cases by wide margins. It turned out Lucent was unable to cope with shrinking sales, rising inventories, bloated cash outlays, and other woes that sent its share value plunging from $80 to 75 cents in two years. As this example suggests, disappointing earnings news is often followed by more earnings disappointments.
Don't Rest Easy with Estimates
Be wary of treating estimates from Wall Street analysts as the be-all and end-all measure for assessing stocks. While it's wise to watch estimates, it's also important not to give them more respect than they deserve. Like we said above, these are simply estimates and should be taken as such.
Moreover, the truth is earnings are awfully difficult to predict. Brokerage house earnings estimates, in some cases, may be little more than educated guesses. After all, companies themselves often are unable to forecast their future accurately. Why should Wall Street observers be any more well-informed?
Just because a company misses estimates doesn't mean it can't have great growth prospects. By the same token, a company that exceeds expectations could still face growth difficulties.
Before getting too excited when a company does manage to meet or beat the expectations, keep in mind companies take great pains to ensure their numbers are on target. What investors often forget is that companies sometimes "manage" earnings to hit analysts' expectations. (To read more, see Common Clues of Financial Statement Manipulation and Top 8 Ways Companies Cook the Books.)
For example, a company might try to boost earnings by recording revenue in the current quarter while delaying recognition of the associated costs to a future quarter. Or it might meet quarterly estimates by selling products at a lower price at the end of the quarter. The trouble is that managed earnings of this kind do not necessarily reflect real performance trends. Investors should try and spot these kinds of tricks when assessing how quarterly numbers match up with estimates.
Look Beyond the Consensus
Recognizing consensus estimates' shortcomings, you can use them to your advantage during the earnings reporting season.
Consensus estimates are basically the sum of all available estimates divided by the number of estimates. So when you read in the financial press that a company is expected to earn 4 cents per share, that number is simply the average taken from a range of individual forecasts. Two different analysts might see the company earning 2 cents per share and 6 cents per share, respectively.
The consensus may not capture what the best analysts think about a company's prospects. A few analysts tend to make remarkably accurate earnings forecasts while others can miss them by a mile. Therefore, it's wise for investors to find out which analysts have the best track record and use their forecasts instead of the consensus.
When there is a lot of disagreement among analysts, the forecasts on a company will be spread widely around the mean consensus estimate. In such cases, a stock could be a bargain based on the most optimistic estimate, but not on the consensus number. Investors can profit if the analyst with the higher-than-average estimate turns out to be on target.
With the limited accuracy of the consensus in mind, share value swings that accompany earnings that beat or miss estimates may be unwarranted. In fact, a drop in the stock price that results from numbers coming up short may create a buying opportunity. Likewise, better-than-expected results aren't necessarily good news either and can offer a good chance to take profits.
Looking Beyond the Sell
While some investors sell right away if a company misses, it's probably more prudent to look closely at why it missed the target. Is the company increasing earnings every quarter? If not, and analysts are lowering their expectations of how much a company can earn, the stock price will likely drop. On the other hand, perhaps the company's miss is more a function of the estimate than its corporate performance. Savvy investors don't rest easy with estimates; they look beyond consensus numbers. (For additional reading, see How the Power of the Masses Drives the Market and Technical Analysis That Indicates Market Psychology.)
The Bottom Line
Analysts take great pains to come up with their estimates for earnings, using a number of different tools including management guidance, past performance, and net income. But these are estimates and should be taken as such—not the be-all and end-all of your investment decisions because of the varying factors that can affect the performance of a company and its stock.