Earnings Estimates as a Control Mechanism, Redux

by: David Merkel, CFA

<< See Part One, Earnings Estimates as a Control Mechanism, Flawed as They Are

One of my favorite topics to write about is portfolio management. That’s because I love my methods for managing equities and bonds. The methods work, but they aren’t a lot of work. So, I enjoyed writing my piece yesterday, Earnings Estimates as a Control Mechanism, Flawed as They Are. And I got two good comments that I would like to develop here. Here’s the first comment:

Actually, David, I think you have left out the more pressing issue with earnings estimates.

The system, such as it is, has evolved as a collaboration between the companies and analysts to promulgate estimates that are deliberately LOWER than is realistic. Both parties know that stock prices do well when they beat estimates, and it is a lot easier to set the bar really low than to actually outperform realistic expectations. I think many small investors don’t realize how the analysts are linked at the hip to the companies they supposedly cover objectively—when the stocks do well, the analysts do well!

This of course is the data shows that 60-70% of companies beat estimates every quarter, even in lousy years, and why you see stocks almost always beat the bottom line estimates even when they fall short of revenue estimates.

Just another way in which the integrity of the markets is in an utter shambles.

I appreciate what you have to say, but it is not something that I did not consider. I omitted it for reasons of brevity, and I will explain why here. If management team lowballs earnings estimates, they raise their forward P/E, which is a drag on their stock price. There is no free lunch here; stock prices converge on the market’s view of future earnings power. A management team can set their estimate of future earnings wherever they like. A high estimate may goose stock prices in the short run, and low estimates may cause stock prices to fall in the short run. But in the intermediate term, actual earnings will mean more to stock prices than any games played with earnings estimates. Managements that cheat eventually get punished.

Here is the second comment:

A comment that reinforces the caveats on forward earnings: Lombard Odier has shown that there is NO correlation between forward P/E and actual returns over the following 12 months (http://media.ft.com/cms/965cca10-b5d7-11df-a65e-00144feabdc0.pdf).

And a question. All measures like the growth in tangible book value per share become considerably more complicated to evaluate when a company grows via a series of mergers. In theory one can do the analysis on each tributary. In practice, getting to know the peculiarities of the accounting in each company involved becomes very time consuming. I wonder how you approach such a case?

On the forward earnings piece, that may apply to the market as a whole but that may not work with individual stocks.

On your question: yes, when we are dealing with M&A the calculations become more complex. Using the measure of tangible book value per share penalizes acquisitive companies, unless they can buy companies for less than their tangible book value per share. There are other issues, in that one must give companies credit for spinoffs and such. I covered that in my piece Cram and Jam. The main question that investors should be asking is: are management teams growing net worth per share for investors on a fair market value basis?

Many do not do that. Instead, they choose a shortcut. The most common shortcut is maximizing operating earnings per share. That measure does not take to account the losses that occur from one-time events and chicanery that comes from buying back stock at prices that are too high.

One more note: I usually avoid companies that do a lot of acquisitions relative to their size, because they tend to underperform.

Final comment

I appreciate all the blogs that quoted my piece yesterday, or linked to it. But there is a misunderstanding. Though I am not crazy about sell side earnings estimates, I still see them as necessary. Why? We need them to allow us to evaluate progress of the company quarter by quarter. To use a gambling term, earnings estimates are “the line.”

We could argue that we don’t need to evaluate companies quarter to quarter, and I’m fine with that. Let’s be like Buffett and say that we would be happy if the stock market were closed most of the time. I could live with that, but most players the stock market could not. So, if we’re going to allow the market to be open every day, then we need a control function to allow us to estimate the change in value of a corporation when its earnings are released.

Earnings estimates are a necessary evil. Please remember that as the earnings season begins.