We are about to be in the heart of quarterly earnings reporting season, the time every three months (commencing in the middle of January, April, July, and October) when companies report their financial results from the just-ended quarter. Prices of individual stocks will rise or fall depending on whether the reported earnings exceed, match, or fall short of investment analysts' (collectively known as Wall Street) expectations, so all eyes will be on the news ticker as these companies roll out their numbers over the next few weeks. The results can set the tone for specific stocks and for the overall market, so we'll take a look here at how the "expectations game" actually works.
The cornerstone of investing is all about determining what something is worth, finding its intrinsic value. When this intrinsic value differs materially from the market value, we have the prospect of an investment opportunity. If I calculate that the intrinsic value of XYZ Corporation is $50 per share and the stock trades at only $30, I need to find out why that discrepancy exists and whether this might make XYZ a compelling investment. If I am buying a house for my family to live in, them I am going to consider what other houses in similar neighborhoods have sold for on a price-per-square-foot basis, so that I have some sense of whether the asking price for a particular house is close to being a fair price. The amount I'll offer and am ultimately willing to pay is going to depend somewhat on how much I really like and want the house (and how my wife feels about it), so that can involve a great deal of subjectivity. However, if I am buying a house to rent out as a piece of investment property, then the price I am willing to pay will be largely determined by the amount of rental income I can earn on the property. Income-producing assets are valued based on the potential they offer for generating income, and that is the simple reason why earnings determine stock prices (even if no dividends are currently paid out of those earnings).
Professional investment analysts develop financial models for the companies they follow, including such factors as a company's sales history, profit margins, and product mix to arrive at a projection of future earnings. This is then expressed as the estimated Earning Per Share (EPS) for each upcoming quarter and for the next year. As we'll see over the next few weeks, the moment of truth comes when a company reports its actual EPS for the most recent quarter. If this number comes in ahead of expectations, then the stock likely will move up on the news. Suppose, for example, that the estimated earnings amount for XYZ Company's Fourth Quarter (Q4) is $.50 per share, with the full or fiscal year (FY12) estimate at $2.00 per share. Last year the company earned, say, $1.74 for the full year, so the expected growth in earnings is 15%--and we'll assume a Price/Earnings (PE) multiple of 15 times future earnings, which puts the stock at $30 per share. If XYZ reports that its actual EPS came in at $.60 instead of the $.50 estimate, then this should be very good news for the stock (assuming that the sales and margins also look good). If business at XYZ is truly that much better than the market expected, then it is immediately apparent that the $2.00 full year estimate is too low, at least by $.10. However, what may happen next is that analysts may start revising upwards their estimates for future quarters, and if they think each upcoming quarter can come in at $.60 instead of $.50, then the full year estimate would go to $2.40. That also means that the growth is better than the expected 15%, so the market may award a higher PE multiple to the shares. If the PE goes to 20 and the expected earnings go to $2.40, then our $30 stock may become a $48 stock. Now, if the EPS had come in at $.40, below the $.50 estimate, just throw all of that into reverse--our $30 stock might belly up as a $16 stock. That is a vast oversimplification, but still the general idea of how the expectations game affects stock prices.
Now let's look at a real-life example. Back in November Dell (DELL, $15) reported quarterly EPS of $.54, versus a consensus expectation of $.47. That looked good at first, but the problem was that the company's top line revenue growth was weak, meaning that the improvement in earnings was mainly due to margin expansion and not to higher sales. The stock sold off and has been trading in the $15 range ever since. When companies report their results, the investment community is looking at all sorts of information besides the "headline" EPS number. The market, as in the DELL example, does not like to see earnings growth without sales growth, because profit margin expansion is not sustainable over the long term. Conversely, great sales growth that doesn't translate into earnings can mean that the company has lost control of its expenses, another unwelcome development. Another thing to which the market pays rapt attention is the "guidance" issued by the company regarding their future prospects. If a company reports blowout, consensus-beating earnings but goes on to say that the next quarter looks lousy because their business in Europe is weak, that's going to be bad for the stock. As we have emphasized before, investing is all about expectations for the future, so if tomorrow looks grim it really isn't going to matter much how great yesterday looked. As companies report earnings, everyone will be paying attention to such comments, especially guidance about Europe.
The earnings reports of some companies will have implications for the broader market and for particular sectors. Apple (AAPL, $420) will report earnings next week (1/24), and this report will be a "bellwether" for the technology sector and likely the overall market. AAPL's last earnings report was their first disappointment in quite some time, but investors have come to understand that the shortfall was due to consumers delaying purchases in anticipation of the new product release. The report next week will be critical because the quarter includes the Christmas shopping season. The consensus estimate is $9.93, with a high estimate of $11.26 and a low of $8.88. Another element to the game here is what is known as the "whisper" number, meaning the amount some analysts truly expect the company to report. The analysts haven't gone "on the record" with that number because it could be too optimistic. I actually expect that AAPL will report an outstanding quarter in both sales and earnings, well above all expectations, because all of the checks indicate a huge demand for iPhones and iPads over the holiday season. If I am correct, this will lift the shares of AAPL and its suppliers, such as Qualcomm (QCOM $56) and Broadcom (BRCM, $32). The important thing to remember, though, is that AAPL is going to have to beat the official estimates by a wide margin for the stock to rally, because the higher "whisper" number is probably already priced into the stock. This does sound more and more like a game, but we just have to understand the rules.
It is important to remember that just meeting expectations is not enough. If my wife goes off to work expecting that I will, in her absence, take out the garbage, feed the dogs, and change light bulbs, then I will receive no accolades for doing what she expected me to do. If I fail to do those things, of course, I am in trouble. However, if I do the expected chores plus wax the floors, wash the windows, and polish the silver, then my stock is going to go up in her eyes, and things will be quite pleasant in the Taylor household. (Actually, if I did all of that, she would probably have a heart attack and drop dead on the kitchen floor. In the interests of her health, I must refrain from overdoing the housework.) As my father used to remind me, no one gets special rewards for doing what they are supposed to do anyway.
Can we use any of this to make better investment decisions, or do we just have to wait for great earnings reports and then pay more for a stock? Actually, there is a way here to make the "expectations game" work for us. Analysts often make revisions to their estimates throughout a quarter, and the direction of those revisions is a pretty reliable precursor to earnings surprises. When we see that the revisions are going up, that can be a signal that business is better at a company than what the analysts had captured in their models, and that often leads to a positive earnings surprise (the reverse is true as well). In his Upside column in The Wall Street Journal ("How to Profit From Analysts' Stock Recommendations," January 14th, 2012), Jack Hough points out how studies have shown that stocks with lots of "buy" ratings from analysts don't, as a group, tend to do better than the overall market. However, another study has shown that when an upgrade to "buy" is accompanied by increases in earnings estimates, a strategy of buying those stocks can lead to improved performance. Earnings estimate revisions are, in fact, a key part of my own investment selection process. At the very least, the next time your broker recommends a stock, you might want to ask him or her about the recent history of earnings revisions. That information can be obtained from the brokerage firm's research reports or accessed on the newswires.
Keep an eye on Wall Street over the next couple of weeks. There will be winners and losers, especially in retail and technology, and these earnings reports will set the market's tone, probably for the next few months. Time to separate the men from the boys (or the women from the girls, if you prefer).
Life is short. Get busy.
Jim
Disclaimer/Disclosure: This blog is not intended to serve as specific investment advice. Stocks are mentioned here for the purpose of illustrating investment concepts, and nothing stated here should be construed as a recommendation to buy or sell any security. My family members and/or I own shares of AAPL, BRCM, and QCOM.
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