Trillionaire Term of the Day - February 25, 2009 - Earnings

Earnings Estimates

Earnings estimates are analysts’ predictions of a company’s future quarterly or annual earnings. Investors, companies, and analysts alike have recognized the enormous effects that earnings estimates have on stock prices. It is absolutely critical to have a good understanding of what estimates are, how they are made and influenced, and how they are compared to actual earnings.

Earnings are after-tax net income. Earnings are incredibly important because they directly indicate a company’s profitability. Financial professionals, called analysts, create estimates in the process of determining stock recommendations. These recommendations include “buy”, “sell”, and “hold.” By recommending hold on a security, an analyst means you shouldn’t buy, and if you already own it, don’t sell. Other ratings include “outperform”, which means a security is expected to do slightly better than the overall market. Similar to outperform is “overweight”, which means that the security should fare better than its particular industry, sector, or possibly the entire market.

When analysts create these recommendations, they also estimate earnings to an exact dollar amount. Right now, analysts estimate that The Coca-Cola Company (KO) will report earnings of $1.5 billion (an earnings per share of $.65) for the current quarter. They come to this dollar amount by estimating revenues and costs. They take the estimated revenue and subtract estimated costs to come to estimated earnings.

Accurately estimating earnings for a company of any size is a complicated and imperfect process. Analysts attempt to predict revenue by implementing forecasting models that implement growth rates, macroeconomic factors, and fundamental information. They predict costs by looking for any possible expected changes of cost including wages, raw materials, sales expenses, interest expenses… the list goes on. Some analysts will even talk to a company’s customers, competitors, and suppliers. The main question that runs through an analyst’s head is, “What might cause revenue and costs to be greater or less than last quarter?” They are looking for change.

Estimating earnings is not a perfect science. Ten different analysts can easily come to ten different dollar amounts for earnings. Even if they come to the same number, they probably considered different factors to get there. To illustrate this point, the lowest analyst estimate for Coke is $1.43 billion and the highest is $1.6 billion. Wall Street factors in the differences of opinion by considering the ‘consensus estimate.’ The consensus estimate is simply the average of all analysts’ estimates. Wall Street adds the estimates together, and then divides them by the total number of estimates. The current consensus estimate for KO is $1.5 billion. The consensus is the number being considered when you read articles or hear the word “estimate”.

When you hear people say, “a company beat earnings” they mean that the company’s actual earnings were higher than earnings estimates. The comparison of actual earnings to earnings estimates is the single greatest short-term driver of stock prices. In most circumstances, if a company beats earnings, stock price will shoot up. Likewise, if a company falls short of expected earnings, the stock price normally falls. This direct impact is why estimates are considered to be so important.

Successful companies usually have a lot of smart people working for them. Smart people know that the estimates are important, and they’ve done a lot to try to alter or influence them. Companies often attempt to drive estimates lower! While at first this strategy may seem counterintuitive, it’s much easier to beat estimates when they are lower than they should be. Companies can influence earnings estimates by delivering ‘guidance’ or reporting bad news early. If a company gives negative feedback on itself or reports bad news, analysts will factor the information into their estimates.

The necessity to beat estimates has become such an essential element of a company’s success on Wall Street that some businesses are driven to acts of desperation. The use of accounting manipulation to boost earnings is widespread. While ethically questionable, companies can use a wide variety of techniques that are legal under GAAP (the set of financial rules all publicly traded companies must comply with) in order to alter their earnings and financial statements in order to make them more suitable for their various agendas.

There is a vast wealth of information regarding earnings and earnings estimates. I hope that this article has helped you gain a basic understanding of estimates and why they are so important in the world of investing. I encourage you to read more articles about estimates by searching for them on our favorite financial websites.

 

-Matt Schwartz

College Trillionaire