Earnings Estimates as a Control Mechanism, Flawed as they are

Why does the stock market pay so much attention to earnings estimates?  Don’t earnings estimates embody the worst type of analysis of stocks on Wall Street?

There is some truth to the thought above.  After all, earnings estimates eliminate all one-time charges.  Now, that makes sense in the short run, but not in the long run.  In the short run we want to estimate the growth in value of the business on a continuing basis.  Thus, we eliminate one-time events.  In the long run we must see how a management team has grown the total value of the Corporation.  To do that, we must factor in all of the one-time events as well as the regular earnings in order to see how they have managed Corporation over time.  Would that one-time events were really one-time events.  And, would that one-time events averaged out to zero.  But truth, one-time events are on average highly negative.  And so, companies with a lot of one-time events typically have lousy earnings quality, and deserve a lower price earnings multiple as a result.

So if there is that much trouble with how we measure earnings as far as earnings estimates go, why do we use earnings estimates?  Most of the value of a Corporation on a going concern basis stems from the future earnings of the company.  Investors want to have an estimate of forward earnings so that they can gauge whether the company is growing at an appropriate rate.

Now, it wouldn’t matter if the system were set up by third-party sell side analysts, by buyside analysts, by companies themselves, or by a combination thereof.  The thing is investors are forward-looking, and they want a forward-looking estimate to allow them to estimate whether the companies are doing well with their current earnings or not.

So long as the earnings estimates are relied on a fair measure of likely future earnings of the company, they become an influence on the current price stock.  For example:

  • If earnings estimates rise rapidly, so will stock prices.
  • If actual earnings comes in above estimates the stock price will have one-time rise.
  • And vice versa for when estimates fall , and when actual earnings are less than the estimate.

Now if earnings estimates were done right, together with growth estimates, by angels did not men, they would serve as cornerstones for estimating the value of corporations.  But our ability to see the future even collectively is poor.  Many things happen that we do not expect, whether from the government or the central bank or wars, you name it.

But even with all those flaws, earnings estimates provided useful function in being a feedback mechanism so that the market knows how to react in general, when earnings are released.

New Problem

But when beating earnings estimates become the be all and end all of the corporate management, we run into trouble.  Knowing that the estimate drives the stock price, makes some corporations fuddle the accounting.  They adjust revenue recognition, they differ recognition of expenses, enter into useless mergers and acquisitions, etc. Most accounting chicanery problems would not exist if beating the earnings estimates was not so important.

So what do we as investors do?  We look at the release of actual earnings with skepticism.  We carefully consider the adjustment of net earnings to operating earnings and asked whether the adjustments are truly reasonable or not.  We also don’t give full credibility to earnings estimates as if they were a sure thing.  Further, we review revenue recognition policies, and all other means to easily adjust operating earnings so we are not deceived by corporate managements.

And, if I can be so radical, we begin ignoring earnings and focus on growth tangible book value per share.  We look at growth cash flow per share net of maintenance capital expenditure.  We do all we can estimate free cash flow, and yet, take a step back and ask how the free cash flow is being used.

Free cash flow is not valuable if it’s being used to buy back stock at a high multiple.  It’s not valuable if it’s being used to do a scale acquisition.  Both of these are forms of dilution to common shareholders.

The key question is this: is the management building the net worth per share of the company?  That’s a lot harder question asking if the current earnings beat the estimate, but if this were easy, they would’ve brought someone else in to do it, not you or me.

PS – I leave aside the issue of intangibles here.  Usually intangibles are worthless.  But some are quite valuable, like the name Coca-Cola, or distribution network that is not easily replicated, or research and development is unique to the Corporation has not yet developed into a product.  All that said, for an intangible to have value, it must produce additional cash flow in the cash flow statement under operations, that do not reflect in the earnings statement.

About David Merkel 144 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website RealMoney.com (http://www.RealMoney.com). Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

Visit: The Aleph Blog

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