Primer on U.S. Corporate Earnings~Part 2
The Earnings Dance
Welcome to part 2 of the Primer on U.S. Corporate Earnings. Let’s look at the dance that’s developed between analysts, investors and companies around the issue of corporate earnings.
What’s included in the filings companies give to the Securities and Exchange Commission?
There are three types of financial statements included in SEC filings: the balance sheet, which is like a snap shot in time of the company’s finances; the income statement, which shows the particulars of a company’s finances during a specific time period, and the statement of cash flows, which tracks company cash. But inside these statements the information is dark and murky, full of twists and nuances.
How do I know which of these items are important when reading an earnings report?
One would think that sales and profit would be what’s most important to investors. That however is rarely the case.
The importance of the items is determined by people called financial analysts. Analysts are a fickle group. Analysts may consider one item for a specific company to be important during one quarter, but ignore that item in the next quarter and focus on something else. For one company, analysts may think inventory levels are important, for another company free cash flow or same-store-sales. The earnings forecast plays an important role as well.
If the company doesn’t favorably report the item the analysts are looking for in that particular quarter, the stock will drop. So a company’s profit and sales may rise substantially, but the stock will drop because the analysts were looking at something else.
What makes for a good or bad earnings report?
Whether an earnings report is good or bad is determined by how the company performed relative to what analysts and investors were EXPECTING. The stock of a company will react not to specific financial items like sales and profit alone, but how sales and profit came in relative to analysts’ expectations. So profit may have risen by 50 percent, but if analysts were expecting it to rise by 60 percent, then the company has missed analysts’ estimates. That’s considered a really bad thing.
How do I know what analysts are expecting?
Each analyst develops his or her own expectation of a company’s quarterly earnings. A third party company asks analysts from many different firms about their forecast. The third party puts all those estimates together and waves a magic wand to determine the so-called analysts’ consensus estimate. There is generally a very narrow range of analysts’ estimates. Every so often a rogue analyst will come up with an estimate substantially higher or lower than everyone else, but that’s pretty rare.
How do analysts figure out what to expect?
Oddly enough, the companies tell them and this is where the dance comes in.
Analysts earn hundreds of thousands of dollars, even millions of dollars a year, and yet they are spoon fed information by the companies. Companies give analysts an outlook, or a range, of what to expect. Analysts would be foolish to develop an estimate that was significantly different from what the company has said.
Sometimes the companies announce their outlooks in public and other times analysts are told the range in private conversations with an investor relations executive or even in a meeting with upper management. It’s illegal for a company to give information selectively to certain individuals, but it goes on anyway. So the company leads and the analysts follow. But there are more steps to this dance.
A smart company ‘manages’ analysts’ expectations. A smart company ‘guides’ analysts into thinking earnings will come out one way, but will actually report earnings better than what they told analysts to expect. Then the company is said to have beat analysts’ expectations. That’s a good thing.
Isn’t that kind of sneaky?
Well, yeah, but the analysts know what is going on and the companies know what’s going on. It’s a dance. Everyone just pretends not to be dancing.
Why would they do that?
Analysts make money be being smart. If an analyst says a company will do X and the company actually does Y, the analysts doesn’t seem very smart. If they don’t look smart they don’t get their big salaries. So analysts turn to the company for information on what to tell investors. Then when the analyst says the company will do X and the company DOES X, the analyst looks smart and makes money.
If this is a dance, how could a company miss analysts’ expectations?
Yep, that’s exactly what analysts would demand to know from the company: How stupid could you be to miss estimates? Why are you making me look bad? Are you that disorganized that you can’t even figure out what your own business is doing? The absolute worse thing a company can do is come out with earnings below expectations. The stock generally will fall.
If analysts aren’t really analyzing the company, what do they do?
The analyst’s job is to act as a pseudo-salesperson to get brokerage and investment banking business for their firm. An analyst may take a company’s management to a big investor and tell the investor that –this company I have with me here today is so good you should buy their stock from the firm where I work. Or the analyst may write a glowing report about the company so that said company will use the analyst’s firm for investment banking business. The firm has actual salespeople as well, but the analyst contributes by providing reports that give the needed spin to make sales.
Then why would an independent investor want to buy stock based on the advice of these analysts?
That’s a good question.
Do all analysts spin their reports?
No. In recent years companies have sprung up that do independent research. These companies make their money by providing non-bias research to big institutional investors and others interested in non-bias research.
Can an independent investor make money without the use of analysts?
Yes, if you educate yourself about how to read financial statements; through the use of websites such as Seeking Alpha, and by purchasing newsletters from independent researchers geared toward the independent investor.
Hope you enjoyed this primer on corporate earnings and happy investing.
Carol Wolf is a freelance ghostwriter and wordsmith. As a reporter she has written up more than 1,000 earnings reports during her 20-year career covering public companies. She can be reached at CarolWolfMedia@gmail.com