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3 Ways the Media Oversimplifies Corporate Earnings

Earnings reports are about more than whether a company missed its earnings per share estimate.

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News reports of corporate earnings are too brief to base investment decisions on.

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What causes a stock’s price to move puzzles many investors and, at times, can stump even the most astute. Simply put, a stock’s price is the present value of a company’s future cash flows. It is a discounting mechanism that is constantly moving based on how investors view a firm’s future earnings potential – not how profitable it was last year, yesterday or even today.

It is not surprising that one of the most significant events that can impact a stock’s price is a company’s quarterly earnings report and the related conference call. Here, management discloses how the firm’s sales, profits and balance sheet have fared over the past three months and discusses these results with investors. However, the financial media has turned these events into a game of earnings per share expectations. In other words, did the company miss, meet or beat analyst forecasts?

Although that summary may be ideal for a short news summary, it often misses the mark in conveying the financial reality. How many times have you seen a headline that a company “beat expectations,” but subsequently see the stock fall? The bottom line is that there’s more to an earnings report than just how it performed versus analyst expectations. Here are three key things that might cause a stock to move in the opposite direction of its headline earnings number.

1. Management guidance. I said earlier that stocks are discounting mechanisms that constantly move based on how investors view a company’s future earnings potential. Thus, it shouldn’t be surprising that one of the bigger drivers of a quarterly earnings report isn’t always how the company fared over the past three months but rather, what is management’s forecast for the next three.

If corporate guidance is materially different from what analysts had in their models, expect the stock to move accordingly regardless of whether it “beat” or “missed” the current quarter. Even if management’s forecast differs just slightly from analysts’, it can significantly alter the medium or longer-term trend and cause investors to change their opinion of the company’s future

Though a valid argument can be made that such minor changes to near-term estimates shouldn’t have a major impact to the company’s long-term picture, it is an unfortunate reality on Wall Street. Companies need to deliver positive forecasts or investors sell their stock and management gets canned. Institutional shareholders need to generate good near-term performance or clients will withdraw their savings and go to another money manager.

2. The quality of earnings. How a company generated its earnings is just as important as the total amount. For example, if it beat earnings per share expectations by 2 cents because of a one-time tax benefit of 5 cents per share, professional investors would actually consider that to be 3 cent-miss. This is because shareholders are looking for recurring earnings – not just one-time gains (or losses). 

Another factor is the relationship between sales and profit margin. A company could post better-than-expected earnings due to having higher revenue. However, if those sales came in at a profit margin that was materially lower than what it has been historically, then the stock could fall despite the earnings “beat.”

This is because investors might be concerned that the company had to lower its prices due to competitive pressures or that its material costs are beginning to rise. Assuming these lower margins persist, now a higher amount of sales are required for the company to meet investors’ future earnings estimates, which may be more difficult to achieve and puts those estimates at risk of being too high. 

Note that the reverse is true as well. A company could actually “miss” its earnings per share estimate because of lower sales, but its stock could rise because the profit margin unexpectedly improved. Now, a lower amount of sales are needed to produce the future earnings that investors expect, and some analysts may even raise their earnings per share estimates.

The amount of cash generated in relation to earnings can also have a significant impact on the quality of a company’s quarterly results and its stock price. A firm can report earnings per share below consensus forecasts but see its shares rise if it unexpectedly generates higher cash flows. This effect becomes even more pronounced for companies with high levels of debt or a history of low cash generation.    

3. Intangibles. This is where it gets tricky, even for professional investors. A company could have good earnings coupled with a solid forecast, and the stock can still drop. The reason could be something management said during the call, or even a “tone” that made investors feel that times are going to be more difficult in the near future. Additionally, it could be that results weren’t as good as a competitor’s that recently reported, so now people are concerned the company is losing market share. 

Many also don’t realize there are two sides to Wall Street. There’s the “sell side,” which includes the analysts that publish reports and earnings estimates that are used as “expectations” and compared to a company’s results. Then there is the “buy side,” which includes the analysts that work for big mutual funds and hedge funds that actually make the investment decisions. Opinions from buy-side analysts can differ greatly from the sell-side. A company can miss sell-side estimates and guidance, but if it’s not as bad as the buy-side anticipated, the stock can still rally.

Often, there’s more than meets the eye when it comes to corporate earnings reports, and it’s not as simple as the financial media portrays it. Individual investors need to do their homework or find a reputable financial advisor who does.
 
Brett Carson, CFA, is the director of research for Carson Institutional Alliance where, as portfolio manager, he is directly responsible for managing several strategies, including perennial growth, long-term trend and write income. Additionally, the Omaha-based research department conducts thorough analyses of companies to identify undervalued stocks that carry attractive upside potential. Investment advice is offered through CWM, LLC, a Registered Investment Advisor.