Beware of Companies That Game the System
When a company handily beats earning estimates for a quarter, the stock market often rewards it with a bump in its stock price.
One of the purposes of earnings estimates that companies issue before the final numbers for a quarter are released is to remove some of the surprise factor.
In the interest of transparency, companies advise stock analysts on where it anticipates reporting earnings for the quarter.
This information is shared with the public so investors can use it to make more informed decisions.
The idea is that the market works best when all relevant financial information is available to all investors.
However, there is a problem with this system.
Companies can advise stock analysts that earnings will come in at one level, but when the actual quarterly numbers are issued, the result may be significantly different.
Some companies may intentionally under-estimate quarterly earnings with the strategy that a pleasant surprise when the number comes in better than expected is good for stock prices.
They are often correct. Companies that consistently beat earnings estimates, which are based in part (sometimes a large part) on advice from the company, usually score impressive stock price gains.
Even if the company is losing money, it may still over-estimate the loss and look good when the real numbers are reported as better than expected.
At some point, analysts and investors may quit believing guidance from companies that regularly under estimate profits and over estimate losses – all in the name of giving a boost to stock prices.
Companies can hardly be criticized for earnings estimates that regularly miss the mark.
Investors and analysts don’t like uncertainty, especially negative uncertainty.
But, they do like pleasant surprises, which could be a higher than expected profit or a lower than expected loss. Either way the stock stands a good chance of gaining.
However, analysts and stock investors can spot a habitual under-reporter and discount the earnings advice.
The lesson here is if you are interested in a company watch them through several earnings seasons to see if their advice is close to the quarterly earnings.
Companies that regularly advise numbers that are worse than the actual earnings are gaming the system.
Be careful of companies that manipulate the system.
One of the purposes of earnings estimates that companies issue before the final numbers for a quarter are released is to remove some of the surprise factor.
In the interest of transparency, companies advise stock analysts on where it anticipates reporting earnings for the quarter.
This information is shared with the public so investors can use it to make more informed decisions.
The idea is that the market works best when all relevant financial information is available to all investors.
However, there is a problem with this system.
Companies can advise stock analysts that earnings will come in at one level, but when the actual quarterly numbers are issued, the result may be significantly different.
Some companies may intentionally under-estimate quarterly earnings with the strategy that a pleasant surprise when the number comes in better than expected is good for stock prices.
They are often correct. Companies that consistently beat earnings estimates, which are based in part (sometimes a large part) on advice from the company, usually score impressive stock price gains.
Even if the company is losing money, it may still over-estimate the loss and look good when the real numbers are reported as better than expected.
At some point, analysts and investors may quit believing guidance from companies that regularly under estimate profits and over estimate losses – all in the name of giving a boost to stock prices.
Companies can hardly be criticized for earnings estimates that regularly miss the mark.
Investors and analysts don’t like uncertainty, especially negative uncertainty.
But, they do like pleasant surprises, which could be a higher than expected profit or a lower than expected loss. Either way the stock stands a good chance of gaining.
However, analysts and stock investors can spot a habitual under-reporter and discount the earnings advice.
The lesson here is if you are interested in a company watch them through several earnings seasons to see if their advice is close to the quarterly earnings.
Companies that regularly advise numbers that are worse than the actual earnings are gaming the system.
Be careful of companies that manipulate the system.
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