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How to Read Earnings Season
by   Mark Wade  

Roughly a month out of every fiscal quarter is given over to something known as earnings season, which is when American corporations report their profits and revenues from the previous quarter. Investment analysts issue forecasts on every stock imaginable, and those estimates are as closely watched as the earnings reports themselves. Investing professionals recognize that the name of the game is not so much how much a companyís earnings have increased, but the extent to which those earnings meet Ė or fall short of Ė Wall Streetís expectations.

With so much on the line for their share prices, corporations have become very good at beating those estimates. In fact, historical studies show that 62 percent of all companies beat their consensus estimates during each earnings season. In the last quarter for reporting, this past April, that figure rose to around 75 percent. According to research conducted by the Bespoke Investment Group, at least half of all reporting corporations have beaten their earnings estimate in every single quarter since the year 2000.

One way in which corporations are able to temper the expectations around them is by issuing pre-announcement earnings guidance reports. Apple, to take one prominent example, has become very good at tamping down expectations. Shortly before reporting its earnings in April, Apple put out a guidance number of 8.5 for its earnings per share; that number eventually came in at 12.1. Thatís an understatement of a whopping 42.7 percent.

Corporations in general have been making a concerted effort to lower expectations. Thereís a trend to lower earnings estimates that has been going on for some time now: Back in April 2011, the average earnings estimate was at $26.04; by the end of the year, the average estimate for the first quarter of 2012 was down to $24.70. That figure kept falling, all the way down to $23.75 by the middle of March in preparation for this past quarterís earnings. Thatís the all-time low ever since this figure has been kept.

With so much effort being put into lowering expectations, a company should be expected to beat its earnings estimates, which means that status is hardly newsworthy. On the other hand, since a minority of companies actually miss those estimates, that presents a much more significant situation. So stocks get only a very mild boost for beating estimates, but a major ding when they fall short.

This past quarter, according to figures compiled by the Wall Street Journal, the average stock that beat its earnings estimate saw its share price go up by just 0.5 percent on the two days before and after its earnings report comes out. But stocks that come up short of their estimates lag by about 4 percent in that same time frame.

Another study showed that stocks are much more likely to exceed their earnings by a huge amount than they are to fall hugely short of their estimates. Last October, Bill Barnhart of the Web site YCharts looked at the earnings reports for one week from the third quarter of 2011. He found that of the180 stocks that reported at least a 10 percent surprise in either a positive or negative direction, the positive surprises outnumbered the negatives by almost 2 to 1. According to Barnhart, 119 stocks exceeded their earnings estimate by 10 percent, with only 61 falling short by a similar amount.

So when earnings season comes around, keep in mind that itís the normal state of things for stocks to exceed their earnings estimates. And those earnings beats are already accounted for in share prices; professional investors expect earnings to reports to come in high. An exciting earnings report, far above the Wall Street estimates, is likely to mean very little to the share price.

The thing to watch during earnings season, then, is not for stocks that are beating their estimates. Itís far more important to take note of those that fall short. If a company canít beat tamped-down expectations Ė thatís news.

 



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