Why You Should Tread Carefully This Earnings Season
Thursday, October 8, 2009 | Bob De DeaRating:
Last night, Dow Industrials component Alcoa (Symbol: AA) upheld the tradition of kicking off earnings season with the first report of the quarter, surprising analysts with a 4-cents-per-share gain (vs. a projected 9-cent loss).While analysts scramble to make heads or tails of the announcement and pundits try to determine whether Alcoa is a bellwether for how the rest of the new earnings season will go, today I want to talk about how earnings season impacts you as an investor.
A Quarterly Snapshot of Financial Health
Why is corporate-earnings season such an event in the markets? As Teeka Tiwari is fond of saying, "Stocks are slaves to earnings."
But what does this mean, exactly? And why are earnings so determinant of a stock's performance?
First of all, earnings are only one part of the picture. In fact, Teeka tells us that 68% of a stock's performance is related to the sector it is in.
Money flows into different parts of the economy (i.e., sectors) at different times. So, when thinking of long-term profitability, the most important consideration is being in the right sector.
When companies issue earnings reports and estimate their future profits, management is assumed to have done its best to create an accurate picture of the current state of affairs and to have carefully mapped out the possibilities for the near term.
I say "assumed to have done" so because there are other things that come into play, like accounting sleight-of-hand, alternative methods of calculating, and unforeseen complications.
Earnings Data a Big Deal to the 'Big Money'
Management then supplies this data to interested parties, among them the institutional investors.
We know that these guys are the ones who determine the direction of the market and the flow of money into (and out of) sectors.
But who are they and where does the money come from?
When we speak of "institutional investors," we're talking about the professional money managers (including organizations, like insurance companies and banks) who control the investment of trillions of dollars. This money can be pooled in hedge funds, mutual funds, and pension plans.
These institutions have dozens of highly educated individuals who have undertaken an in-depth analysis of economic models. These analysts are the ones who help institutional investors decide what to buy and sell ... and when.
They take the data from the corporate management teams, crunch it further, and then make their own predictions by creating financial models that give a value to a company based on its historical performance.
They usually concentrate on a limited number of companies or a specific sector and study them intimately. (For example, Morningstar.com has about 200 analysts covering some 2,000 stocks.)
What do they use as a basis for these models? Earnings.
Model Portfolio, Model Performance?
These analysts construct stock-valuation models based on past earnings and, more importantly, they also project future performance.
Obviously, since the stock-valuation models from different analysts are not going to be the same, their future earnings estimates cover a range of predictions, from low to high.
(Generally speaking, the narrower the range -- i.e., the closer the low and high are -- the more confidence one can have in the estimate.)
And, although there are different scales for earnings (e.g., five-year forecasts, quarterly projections), we are limiting our discussion to near-term earnings estimates.
The 2 Terms You Need to Know
Before we go any further, I need to quickly define a couple of terms that most of you are probably already well-acquainted with, so I'll ask you to bear with me for a paragraph or two or three.
Earnings Per Share (EPS)
The earnings per share, or EPS, is a figure you get when you divide a company's profit (net income) by the shares of common stock outstanding.
For example, both Company ABC and Company XYZ earn $10 million. But Company ABC has 20 million shares outstanding, while Company XYZ has 50 million shares outstanding.
So, Company ABC has earnings of 50 cents per share ($10 million divided by 20 million), while Company XYZ has an EPS of 20 cents ($10 million divided by $50 million).
Price-to-Earnings Ratio (P/E)
EPS is also the bottom figure of another important ratio, the price-to-earnings ratio, or P/E.
That's what you get when you divide the stock's price by the latest 12 months of EPS, and it signifies the premium investors are willing to pay for each dollar's worth of earnings.
In general, the lower the P/E, the "cheaper" a stock's price relative to earnings.
(Remember, a stock's price taken by itself is practically as meaningless as an arbitrarily assigned value.)
Here's an interesting historic chart of the S&P 500 P/E (the P/E ratio is in red):
At this time last year, the P/E ratio for the S&P 500, based on trailing 12-month earnings, was around 25. (The year finished at a P/E of 60.) Interestingly, the P/E for the period ended Sept. 30, 2009, puts the ratio just above 140. (That's $140 that investors are paying per dollar of earnings!)
What Does That Mean for Individual Stocks?
OK, just in case your eyes are starting to glaze over, let's look at an example.
Let's say an analyst decides that the P/E for Stock 123 is 10. He does a little calculating and works out projections for performance, anticipating future EPS at $3 a share.
This means that this analyst would consider the stock a "Buy" at any price below $30 (10 x $3).
If he were to revise his earnings estimate upward to, say, an EPS of $3.50 a share, this would increase his recommended buying price to $35. Raise the estimate; the stock price should follow.
Now here's the deal. Circa 1990, about half of the companies issuing earnings estimates met or exceeded them every quarter. These days, we're lucky to see a company meet or beat estimates that have been lowered.
Lower Expectations, Better Actual Results
Before the market went into meltdown mode during the past two years, we were actually seeing closer to 80% of companies meeting and beating estimates. How was that possible?
The management at these publicly traded companies started to realize that, rather than run the risk of not meeting estimates, it was always better to lower expectations and then exceed them. So, they started giving these analysts figures that low-balled their own expectations of earnings.
The analysts perpetuate the trend by issuing their own conservative earnings estimates. Why? Because this enables them to give far more "Buy" recommendations to their clients than "Sell" recommendations.
If an earning estimate gets raised, a lot of people pay attention. Those stocks are then likely to outperform the market. If it gets lowered, even more people pay attention.
Of course, those stocks will likely underperform. (When actual earnings exceed or fail to meet the earnings estimate, it qualifies as a positive or negative "earnings surprise.")
Then, next quarter, the cycle starts all over again.
Just remember that, in this turbulent market climate, the P/E ain't what it used to be. So many stocks have lost ground that their P/Es are at historic lows. So, tread carefully.
Don't, however, lose hope. Even if it seems the whole world's turning upside-down, know that inevitably things will settle, recognizable patterns will again emerge, and companies will once again have faith in their own earnings estimates.
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Bob De Dea
Guest Contributor
The Tycoon Report
