Since the reporting season has arrived I thought this would be a valuable reminder, and especially for our new members. It’s direct from the Knowledgebase.
Saul
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 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 or missed analysts’ 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?” What matters to me is that the company is growing earnings at 75%, and if the company sells off because of an “earnings miss” (which is a ridiculous term for a company increasing earnings by 75%), I might take advantage of it by adding to my position.
I base my purchase decisions on how well the company is doing, and my evaluation of how it will do in the future, and how well its price matches its prospects, rather than whether the company came in two cents above, or two cents below, what the analysts predicted.
Evaluating company results against consensus analyst estimates can produce perverse and peculiar results. Consider this hypothetical: A small stock with three analysts following it has an average estimate of 50 cents for the quarter. Another “analyst” representing a firm that is secretly short the stock, puts in an estimate of 82 cents. This raises the “average estimate” to 58 cents. By raising the estimate he sets the company up to “miss” estimates. After all, it doesn’t matter what the actual results are, just whether they met expectations. Right???
Sure enough, if the company makes 53 cents, what would have been a nice beat becomes a 5 cent miss. The stock sells off for a few days, until people figure out that 53 cents was a very good result, and meanwhile, the firm closes out its short at a profit. Pretty ridiculous, isn’t it. But this hypothetical scenario could, and probably does, play out in the current market.