Earnings Miss, Stock Price Hammered

by: Lee Hoffman

Summary

Stock misses by pennies.

Stock goes down huge percentage.

Why?

Like many investors, I have always wondered why when an earnings report comes out that is fractionally lower than what the analysts called for, the stock is taken to the woodshed. So, what in the world is the big deal when a stock's earnings come out off by pennies?

Investors purchase stocks for future earnings. The past is the past, and most of the research an investor can do is always a backward glance at the company's history. We can glean P/E, cash flow, gross sales, etc., all of which is helpful to know how the company has been run, but doesn't really tell us what the company will do going forward.

Enter the analyst. Their job is to forecast what the company will do going forward, not what the company has done in the past. When companies trade at lofty P/E ratios as they are today, an investor must be concerned with how the future growth of the company impacts the present ratios of cash, P/E and other metrics. This gives us a window to determine if paying a premium in those areas today will be rewarded with growth and earnings going forward which will serve to make today's price reasonable.

So, how exactly does an analyst determine what the company's future earnings will provide? After all, they aren't employees, they have no inside information as to future profits or sales, they aren't skilled enough to foresee future trends first hand. The answer is, they rely strictly on the company's executives' statements of future performance.

The accuracy of how the top executives portray their company's performance is a barometer of not only the executives' understanding of their business, but of their ability to run that business. It must be remembered that executives are motivated to be conservative in their forecasting as when and if they beat estimates, their stocks soar upward. If they miss, their stock prices suffer.

By reviewing how often in the past analysts were correct, and how many times they underestimated or overestimated earnings, we get a reflection of what they were told by management, and thus how effective and knowledgeable management has been in the past. Analysts' and management's frequent misses speak volumes as to how the company is run.

Much has been written about the Fastgraphs by Chuck Carnevale and its functionality in providing paralleled guidance as to earnings, P/E, cash flow, historical stock pricing as it pertains to these areas as well as other vital tools for analyzing performance and stock valuation. Many writers on SA often refer to and use the Fastgraphs in their writings on various types of equities.

There is however, one vital tool that isn't often mentioned in the articles that I've seen. That tool is the analyst's history of hits and misses over various time frames including a pie chart of one-year and two-year accuracy in earnings predictions. If one considers that this is a window into management's skills and ability, this vital piece of history should not be overlooked. In fact, it could be the most overlooked tool for individuals and financial advisors in determining if and when a position in a stock should be initiated.

The Fastgraph tool provides the user with the ability to determine the future valuations based on the estimates of future earnings. The accuracy of future earnings estimates can be determined by how accurate they have been in the past. If a company historically has presented accurate information to the analysts, the earnings estimate will be lots of hits, or misses to the upside. This gives credence to the future estimations. If the hits are infrequent, and misses are to the downside, the opposite can be gleaned. I know of no single place to obtain this history of analysts' accuracy.

Of course, no prognostication tool is perfect and certainly management can occasionally drop the ball due to unforeseen events, unexpected market adjustments, political obstacles, etc. Investors should always be aware of the macro events which may impact the company's performance and hence the stock price. After all, "predictions are hard to make, especially about the future." This information can be a vital part of any investor's toolbox.

Disclosure: I/we 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.

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