October 27, 2009 in Business

Companies’ low earnings forecasts make beating analysts’ outlooks easy

Dave Carpenter Associated Press
 
Associated Press photo

Trader Paul Maguire works on the floor of the New York Stock Exchange last week. When companies top expectations, share prices often get a quick lift. At the same time, though, investors are often misled about the real state of the business.
(Full-size photo)

CHICAGO – More than 80 percent of major companies reporting third-quarter results this month have beaten Wall Street expectations. So is business that good? No. Are companies gaming the system? Yes.

Corporate America has a habit of low-balling the earnings forecasts used by analysts to determine their estimates. That way, the bar is lower, and companies can easily jump over when the quarter’s results are announced – even if profits and revenues have fallen off a cliff.

“Over the last decade, there’s been a distinctive tendency for companies to underpromise and overdeliver,” says Dirk van Dijk, chief equity strategist of Zacks Investment Research. “Lately companies are being even more cautious. They realize investors can very harshly punish any company that disappoints.”

Beating expectations generally gives share prices a quick lift, but the news can mislead investors about the real state of the business – and just how far this economic recovery has to go. In fact, of the companies reporting third-quarter results so far, 60 percent have posted lower net income compared with a year ago.

Still, the recession has, if anything, accelerated the flow of positive earnings “surprises” as companies play it safe and issue more conservative earnings forecasts. Over the past two years, 65 percent of earnings reports have beaten estimates. Even after last fall’s financial crisis, the following two quarters produced nearly twice as many beats as misses.

And this quarter, 81 percent of the first 199 companies listed on the Standard & Poor’s 500 index that reported earnings came in above expectations.

The expectations game works like this.

Corporation X announces weeks or months ahead of time that it expects to earn, say, 55 to 60 cents per share. Analysts look at various measures of the company’s financial and operating performance while compiling forecasts, but rely heavily on guidance from management. The resulting consensus forecast might be around 57 cents a share.

On earnings day, the company then reports 61 cents per share.

It can rightfully say it beat analyst expectations, and shares rise. Other investors jump on the bandwagon.

The company has some ability to control the number since analysts and most media focus on the so-called adjusted earnings, which can leave out huge one-time charges such as write-offs for restructuring expenses that otherwise could drag down overall results.

The expectations game has been played since the 1990s, when analysts’ aggregate predictions became widely available on the Internet.

But the focus on expectations can distract investors from more meaningful numbers.

This past summer, earnings stories trumpeted how banks did better than expected.

But in stressing the surprise factor, many investors lost sight of the fact that earnings were down considerably for most banks and that troubles still shadow the sector.

In the past 15 years, 61 percent of earnings reports by the nation’s largest publicly traded companies – those listed on the S&P 500 – have surpassed Wall Street’s consensus estimates.

Only 21 percent fell short, while 18 percent matched estimates, according to Thomson Reuters data.

There has never been a single quarter during that period when more companies have missed earnings than beat the Street.

Some companies are more blatant about managing expectations than others.

Apple Inc. is notorious for low-balling its outlooks.

The computer maker topped analysts’ estimates on Monday for the 27th quarter in a row.

It has not come up short on earnings day since the first quarter of 2001. Apple declined to comment on the trend.

Then there’s Cisco Systems Inc., which once beat forecasts by exactly 1 cent per share for 13 straight quarters, from 1998 to 2001.

Coming within a penny so many times during that period merely shows the company was “conservative and transparent in communicating quarterly business conditions to investors,” according to spokesman Terry Alberstein.

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