Stock Market Wizard, U.S. Investing Champion Mark Minervini Shares Ideas and Wisdom Here FREE!
August 02, 2013
Wall Street analysts keep a close watch on the performance of the thousands of publicly traded North American companies. One of their main jobs is estimating how much those companies will earn on a per-share basis each quarter.
Companies often work very hard to "manage" analysts' expectations, because they know that missing the consensus earnings estimate for a quarter -- even if only by a penny or two per share -- has come to mean that their stock price may get pummeled. By contrast, a company that significantly beats analysts' consensus estimates is likely to see the price of its stock jump. The latter is known as a "positive earnings surprise," and it's obviously something that existing shareholders like to see as well.
One "surprise" does not make a trend, however. Check out analyst information to see whether this is another in a string of positive surprises for this firm -- which would be positive. If not, you might want to wait another quarter before getting too excited.
Basically,Wall Street securities analysts all work pretty much the same way. They tote up all the contracts that a company says that it has or will have with customers, apply the profit margin that the company says it expects to earn from those sales, subtract a certain percentage for taxes -- and voila, they have an earnings estimate for the next quarter or year.
Most of the ingredients for the estimate come from guidance that the company offers in the form of press releases, conference calls or personal, one-on-one discussions. But some analysts add other elements to the recipe: One analyst might visit the company’s customers and discover that sales of certain products are not as brisk as the company has publicly declared. Another might determine that the company is going to qualify for a lower tax rate than is generally expected. Another might determine that a company faces a price war that will grind down profit margins.
For the country’s oldest and most established industrial concerns, analysts’ estimates are usually fairly accurate. But estimates for the country’s newest companies, and particularly high-tech companies, can range all over the map. The mean estimate therefore amounts to a consensus expectation of results for the coming quarter.
Companies that consistently fail to match or exceed analysts’ consensus estimates tend to see their stocks sink faster than their peers. That’s because analysts hate to be fooled with negative surprises. They are disappointed to learn, for instance, that a company expected to enjoy a 40% profit margin on a product line but only got 30% margins because expenses got out of control.
Analysts often punish companies that surprise them with lower-than-expected earnings by revising future earnings estimates -- and targets for share price -- downward. Investors, in turn tend to punish companies that suffer this cycle consistently under the so-called cockroach theory, which holds that, like the insects, if there are two around, there's very likely to be a third in the offing.
Companies that consistently beat analysts’ consensus estimates tend to see their stocks rise faster than their peers. That’s because investors love to learn that a company is actually growing its profits faster than forecast--apply the same price-earnings multiple to a higher level of earnings and the stock price goes up. Analysts reward positive surprises by revising future earnings estimates -- and targets for share price -- upward. And some investors build a buying strategy around this earnings surprise cycle.
By itself, however, a positive surprise is not a reason to buy or hold a stock. You should examine a company’s future earnings expectations independently to determine whether another positive quarter is likely, and whether the price of obtaining a share of those earnings is reasonable. Also, be aware that there has been a growing tendency to focus on the "whisper number" for a company's anticipated earnings. This estimate tends to be higher than the consensus estimate. So these days, a company can beat the consensus estimate but still see its stock price punished because it failed to reach the "whisper" figure.
The best situation is when the high estimate is exceeded, the company raises guidance and the stock price reacts positively. However, if a company misses estimates by a meaningful amount or if the company makes a negative statement about future earnings - known as an earnings warning - and the stock price reacts negatively, in most cases the stock should be sold immediately.
Caution is in order: A company’s earnings -- the "bottom line" of these quarterly reports -- are not always what they seem. Earnings -- and the widely-followed price-earnings (P/E) ratios that depend on them -- are subject to various accounting techniques and may therefore be misleading. Some companies, for example, use particularly aggressive accounting practices, and as a result their earnings are considered "poor quality" since they may be more a reflection of creative arithmetic than business success. All this leads some analysts to prefer cash flow as a better indication of how a company is doing than earnings.
To get a better handle on a company’s earnings report, you’ll need to delve more deeply into the story behind the latest numbers. Start with the company's press release announcing its financial results. How did it explain its performance? Remember that operating profits are a better guide than anyextraordinary items when trying to understand the overall direction of the firm.