The Ugly Truth About Earnings Estimates

banker-xYou may have seen recent news reports that Chevron’s first quarter earnings came in 7.5% below analysts’ estimates. This was the ninth consecutive quarter where the big oil company has missed its estimates, so obviously their shareholders are worried over this negative trend.

I’ll let the talking heads on CNBC debate Chevron’s drop and the reasons for it. I’d rather expose the ugly truth about earnings estimates and why they may not be as helpful to investors as you think.

Decoding EPS Estimates

One of the most-watched indicators of changes in a stock’s price is how close a company comes to matching its earnings per share (EPS) estimates. The consensus earnings estimate is based on what the majority of investment analysts say will be a company’s earnings that quarter.

But who are these stock swamis and why should you care what they have to say? In short, these are the guys who pore over industry data and news briefs to figure out which way a company’s earnings are headed.

There are two types of earnings that you’ll often hear about. Trailing earnings are earnings from the past 12 months, and those numbers are what many investors look at when analyzing a stock. The “e” in “p/e ratio,” for example, uses trailing earnings. But analysts are more concerned about leading or future earnings — earnings projected for the upcoming 12-month period.

Earnings per share simply means the total profit a company made, divided by its outstanding shares. So a company that earned $80 million in a quarter and has 200 million shares earned 40 cents a share for the quarter.

Failing to meet these earning expectations can be disastrous for a stock. If the consensus on Wall Street is that Company ABC ought to report earnings per share of $1, but it actually reports earnings of 75 cents, the stock price will likely drop like a lead balloon when that news becomes public. In fact, just meeting or barely beating analyst estimates can hurt a stock if the market was excessively optimistic to begin with. On the other hand, a stock that surpasses analyst expectations is likely to fly higher, based on the same logic.

The analysts all call their predictions into the companies that track these numbers, such as Zacks and First Call. These services assemble analysts’ estimates of future earnings for thousands of publicly traded companies, detailing how many estimates are available for each company and the high, low, and average estimates for each. And both of these companies offer individual investors access to these earnings estimates and other information that can help evaluate stocks — subscribers get more complete access.

On the street, different analysts carry different weight. The most influential analyst in a particular sector is known as the “ax.” A top analyst can move a stock or a whole sector with revised estimates. Different analysts use various forecasting models to determine what a company’s magic figure should be. Even the number of analysts looking at a stock will vary depending on whether the company is a widely followed name.

Analysts Make Mistakes, Too

Analysts are better predictors than, say, Nostradamus, but they’ve been known to get it wrong. In 1997, when Oxford Health lost a staggering 62 percent in one day, not a single analyst who covered it issued a warning. In fact, 15 of Oxford’s 19 analysts had the company rated either a “buy” or “strong buy.” Nevertheless, looking at combined predictions will give you a decent indication of an individual stock’s prospects.

Keep in mind that no single factor, even the consensus earnings estimate, is sufficient reason to buy or sell a stock. That’s because by the time you’ve heard the analysts’ estimates, so has the rest of the civilized world. It’ll probably be too late for you to take advantage of the news unless you got in early because you had access to some accurate “whisper numbers,” the market’s unofficial rumor mill.

Some stocks have become expert at dampening analyst expectations, so that when they do announce their actual numbers, they exceed the pessimistic forecasts. It’s a tricky game, though — investors seem to account for that phenomenon by punishing the stocks when they come out in line with estimates.

Note from Midas Legacy Editor: “Banker X” must remain anonymous for our purposes, but in his official capacity he’s a CNBC-quoted bestselling author. A former investment banking insider, Banker X is a multi-millionaire as a result of his inside contacts and continues to provide spectacular profits for subscribers to his C.H.I.R.P. service. Check your email for your exclusive invitation.

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