It is an exercise that plays out every quarter with great fanfare. It is also a process to which the largest firms on Wall Street dedicate significant resources. And it serves as a primary information source that many experts and the media cite in valuing the market and projecting its future performance. It is the analysts' earnings estimate game. And it is arguably the greatest farce on Wall Street.
You can hear the proclamations daily in the financial press. Such and such company managed to "beat" consensus analysts' earnings expectations. Or while the stock market might appear expensive today based on historical valuations, it is attractively priced on a forward price-to-earnings ratio basis. Without a doubt, a variety of very useful information can be gleaned from taking the time to dissect the details of the quarterly earnings reports issued by companies. Investing 501 recently wrote an outstanding article on the value that can be added by exploring quarterly conference call transcripts to gain a better understanding about a business. And Seeking Alpha is a tremendous resource for this purpose. But on the most part, the headline grabbing "beat," "met" or "missed" expectations associated with the quarterly earnings announcements is often nothing more than pure rubbish.
A look at these analysts' earnings estimates through a variety of perspectives reveals the flaws associated with the process that dominates so many headlines in the financial press.
Earnings Forecast Bait And Switch
First, a common pattern associated with analysts' earnings forecasts is that they are often wildly optimistic when looking out into the future. These lofty projections are then used in calculating the forward P/E ratio to help explain why stocks are more attractively valued. Ultimately, stocks almost never come even close to matching up to these initially lofty projections, leaving investors holding something that is often much more expensive than the analyst community indicated it would be.
A review of recent history shows the degree of this disparity between initial optimism and eventual reality associated with analysts' projections. In September 2012, the projected 12-month operating earnings per share for December 2013 was projected to be $115.26. So while the S&P 500 Index (NYSEARCA:SPY) was trading at a more fairly valued 15 times trailing 12-month operating earnings at the time (or 16.5 times trailing 12-month as reported earnings, a reading that is typically less cited in part because it usually makes the market look more expensive), analysts at the time could point to the notion that stocks were instead attractively valued in trading with a forward P/E ratio of 12.6 times 12-month operating earnings forecast a little more than a year later in December 2013. Suddenly and almost magically, a fairly valued to somewhat expensive stock market at 1460 on the S&P 500 Index at the time is suddenly cheap! All that was needed to perpetuate this notion were the analysts' earnings forecasts.
One of the keys to make this hold up in reality is the accuracy of these earnings forecasts. And analysts' almost always wildly overshoot in this regard. Returning to our December 2013 example, when the final numbers were officially in for the fourth quarter in April 2014, the actual 12-month operating earnings per share came in at $107.30, which is nearly -7% below the early forecast from September 2012 and was steadily revised lower along the way. So in reality when the final numbers came in, the stock market did not turn out to be the dirt cheap 12.6 times earnings implied by analysts' forecasts. It was still a fairly reasonable 13.7 times earnings, but investors ended up paying more than a full dollar more for the earnings that were finally delivered versus what was initially advertised. The only dilemma is that investors poured into the market all along the way in part on the expectation that the economy in general and earnings in particular were going to accelerate by far more than they actually did. The end result is a stock market that was once trading at 15 times trailing 12-month operating earnings is now trading at over 17 times today. In other words, the stock market is roughly 15% more expensive now than it was before.
This is a process that we see repeated over and over again, quarter after quarter. The initial 12-month operating earnings forecast for December 2015 were recently released, and the S&P 500 Index is projected at $137.34 per share, providing a forward P/E ratio of 13.6 times that looks far better than the more than 17.2 times earnings today. Somehow, I suspect we may end up well short of this lofty projection when it's all said and done.
Everybody Loves A Winner
It is extraordinary how many companies manage to "beat" analysts' earnings expectations. According to S&P, 68.2% of companies in the S&P 500 Index have reported actual earnings per share for the first quarter of 2014 that have been higher than the average earnings per share estimate from analysts. This marks an improvement from the 63.9% beat rate from the fourth quarter of 2013, which was more consistent with the long-term average for companies since the turn of the millennium. As for the rest of the companies in the first quarter of 2014, 9.4% of companies "met" analyst expectations, while 22.8% of companies "missed" expectations.
I need go no further in providing data on this point, as two fundamental flaws immediately present themselves.
Look Through These Rose Colored Glasses
First, if one were to naively take this practice as credible and honest, it is extraordinary how bad the analysts are at this exercise. If the objective of the analyst is as implied to accurately predict the quarterly earnings of companies, what the data above suggests is that they are badly wrong an overwhelming majority of the time. Moreover, a clear and repeated skewness exists in how analysts are wrong, as they continuously underestimate the earnings that companies are reporting each quarter. This raises a most important question. If this was truly a statistically honest forecasting exercise, why haven't analysts by now adjusted their models to correct for this obvious flaw in their approach? After all, if these estimates were really worthwhile, we would expect to see a generally equal percentage of companies "beat" and "miss" consensus earnings expectations each quarter with the mean residing where companies "meet" expectations. Of course, the answer once our rose colored glasses are removed is obvious, as the earnings estimate game is a self-serving exercise for those that provide them. This is a very important point for investors to keep in mind when considering these quarterly earnings headlines, if at all.
The Wall Street Shell Game
Second, a clear contraction also exists in the data shown above. According to S&P, 63.9% of companies reported earnings that beat expectations in the fourth quarter of 2013. But wait a second. Did we not just go through an exercise where we showed that analysts had initially projected earnings to come in at $115.26 per share for the S&P 500 Index only to have it come in -7% lower at $107.30 per share once the final numbers came in. How can this possibly be the case that earnings per share on the entire index came in roughly $8 below analysts' expectations, yet an overwhelming majority of companies at 63.9% reported earnings that were above analysts' expectations with another 25.3% meeting estimates and only 10.8% missing expectations. Was it the result of a catastrophically bad quarter by a few mega-cap companies in the index that led to this outcome? Of course, this simply cannot be the case, because we see this type of set up take place almost each and every quarter where earnings end up well below initial analyst projections but a vast majority of companies beat earnings expectations. How can this be? Is it magic?
Instead, it is all part of the shell game. Analysts often begin by setting high earnings expectations. Then, as the quarter progresses, they gradually lower earnings expectations toward reality. For example, according to FactSet Research, the average decline in analysts' earnings estimates through the mid-point of the quarter over the last decade has been -2.7%. This is a big downward revision, particularly when considering that it occurs repeatedly, quarter after quarter, for forecasts further out the time horizon. And these downward revisions continue all the way up until companies actually report quarterly results. How then are they beating estimates? Because many companies are beating an estimate that was repeatedly revised lower throughout the quarter. In short, it is the equivalent of stepping over a bar that is being managed low enough to make sure companies can clear and "beat" it. As a result, the information that can be derived from this practice is largely useless other than the flashy headline it generates for the financial press and the animal spirits it might inspire. Perhaps the only point that is notable is when a company "misses," for it is in many cases is a sign of how much a company may be struggling at any given point in time. A change in a company's forecast for the future is also usually worth paying attention to as well. Otherwise, the real information is in the details, not the headline. And the conclusions are in many cases vastly different than what the headlines might imply.
While they certainly dominate the discussion in the financial press, analysts' earnings estimates should be taken with a massive block of salt. Instead, investors are best served to look past the headlines and dig into the details provided by the quarterly earnings calls and transcripts along the independent analyses that are derived from them in places like Seeking Alpha and elsewhere. For while the headlines may certainly sound exciting, the truth that is so useful in supporting sound investment decision making is always found in the details.
Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I am long stocks via the SPLV and the XLU as well as selected individual names. I also hold a meaningful allocation to cash.