Company Earnings – Comparisons
A lot of making money in the market is knowing how differentiated industries and companies and investments compare to each other, and themselves. You need a baseline to determine if a stock is worthy of your investment dollars, and the best comparison is growth.
Good companies grow, and bad companies shrink or are stagnant. Growing companies beat estimates, and these days investors focus way too much on companies “beating” their numbers.
Now I don’t necessarily agree that comparing a company to analyst estimates is the best way to measure a company, and I can certainly think of other ways that would be much better. However, this “system” of analysts estimates and measuring companies on a quarterly basis is the one we have.
The easiest comparison is saying if a company missed, met, or beat those analyst estimates. My objective is not to change the system, but to warn you of a problem and hopefully give you a chance to save money, or better yet, make money from it.
Good companies grow. They grow by executing their business plan: increasing revenue, improving margins, and making more and more money. When good companies grow, they typically beat their estimates and the stock goes up. Good companies equal good profits.
However, there is another way companies can beat their estimates. Bad companies can pretend to be good; by cheating to beat their estimates. How do they do this? Simply, they lower the estimates that are being published on the street. It sounds almost too simple to be true, but it happens. The analysts, supposedly independent of the company, are supposed to analyze companies and provide well organized and thoughtful rationale for a company as an investment. In this process they build a financial model (the estimate) and develop a target price.
These analysts are supposed to make assumptions, and sometimes they get those assumptions wrong. When this happens these “experts” become embarrassed. They look bad in front of their clients, the very same people who are paying a lot of money for their estimates and thoughts!
In the financial world, an analyst is only as good as their last call. So with this kind of pressure, it’s in the best interest of the analyst to sandbag – to lower estimates below where they should be. These reductions in estimates can sometimes be quite substantial and guess what . . . the companies beat them – and the analyst looks good.
Now the analysts are not alone in this thinking. The companies are doing the very same thing! Management often has significant amounts of stock in the form of options – options that are only worth something if the stock goes up. They know the game, when they talk with analysts and investors, management sandbags as well. So everyone sandbags, companies beat estimates, stocks go up and everyone is happy.
Except. . . . except when companies beat their numbers quarter after quarter after quarter, and investors expect it, and analysts expect it. Everyone starts expecting companies to beat their numbers and suddenly the “whisper number” starts to take shape! The whisper number is the unofficial number that companies need to beat, which is always higher than what the analysts have published.
Now you see it coming . . . like a runaway freight train, the increasing expectations start to catch up with the company and they miss, they always do. Good companies miss and the stock prices fall. When this occurs, many experienced investors see this as an opportunity to buy shares at an attractive price.
I believe this very issue is taking hold in a widespread way in today’s market. Last quarter, analysts estimates across the board were lowered, and today, companies are widely outperforming these abnormally low numbers. Next quarter these quarter-to-quarter comparisons and related growth are going to be very hard to beat! We are clearly setting ourselves up for future pain – the pain of bad comparisons.
Category: Stocks
