With the Earnings Season starting I thought I’d repost this from the FAQ/Knowledgebase, that Neil so kindly keeps for us:
* I have some thoughts on the Estimates Game. I exaggerate a little for the clarity of the message, but what I am saying is essentially all true. I hope you find these ideas useful:
The whole earnings and revenues estimate game that the analysts play has put the company CFO’s, who give the outlooks, in a no-win situation. Here’s how it has come to work over time:
It doesn’t seem to make any difference how good or bad the actual results are, whether they are up 3%, or 30%, or 70%, or more. The only thing that the headlines pick up is whether the earnings beat the analysts’ estimates or missed the estimates. (Who cares???)
For example, a company whose earnings are up just 3%, but beats estimates by a nickel, will get screaming headlines. The headlines won’t say “ABC earnings only up 3%!” Oh no! The screaming headlines will say “ABC beats estimates by five cents!” The price will undoubtedly rise.
On the other hand, a company whose earnings are up 70%, but misses estimates by two cents, will get equally screaming headlines, not saying “DEF earnings up an amazing 70%”, but saying “DEF misses estimates!!!” The price will undoubtedly fall.
The whole estimates game is only about whether the earnings and revenue beat or miss a number that some analysts have picked. It totally ignores the question of how well the company is actually doing, and how good (or bad) the revenues and earnings really are.
However, the companies aren’t stupid. They have figured this out. And they have started to give lower and lower estimates for their next quarter, picking numbers that they are almost certain to beat (by a lot). They don’t want the bad publicity of missing analyst estimates. (Again, who cares!!!)
So what happens? The companies give low estimates and the analysts say “Good earnings, but disappointing estimates for the next quarter. We’re downgrading them from a buy to a hold.”
Thus the companies are screwed whatever they do. If they estimate high, where they think they will be, and miss, they get the “missed estimates” headlines, and if they estimate low, to let themselves beat estimates handily, they get the “disappointing estimates” headline. They lose either way.
How do we as investors deal with this puzzle. Think “How is the company doing? How much are earnings and revenues actually up?” Ignore the “missed by 2 cents” headlines if earnings are up by 40% or whatever. What the analysts had estimated doesn’t matter a hoot in the long picture, and if a stock sells down in spite of great results because of “missed by 2 cents” headlines, treat it as an opportunity.
Just my opinion. [Post 1315]
The message is don’t get caught up in the missed estimates, beat estimates, game. Think about how good (or not good) the results actually were!