It is a public secret that companies try to manage analysts’ earnings expectations in order to consistently beat or at least meet them. Not shockingly the ratio of positive to negative earnings surprises often exceeds 5. Therefore an earnings beat by 1 to 3 cents is considered a non-event, because the news was already discounted in the stock price. Only a small percentage of companies will report a game changing earnings that will impress the market.
Some companies have the tradition to give the street a clue about future earnings. Such news is called earnings guidance or earnings pre-announcement. Companies that suspect that there is a slight chance of missing analysts’ expectations will lower guidance in order to convince the Street to lower its estimates to an easily beatable level during earnings season. Only a small number of companies report positive guidance. The ratio of positive to negative guidance in a typical quarter is around 1:3, often smaller. Therefore positive earnings guidance is an important event that alters the market’s expectations. When expectations change, perceived valuation changes and prices move.
Why would a company guide higher and risk to miss earnings’ estimates when it reports? It is very simple. It doesn’t risk anything. It is absolutely confident that despite higher guidance it will beat again, often by a good margin. In addition to potential positive price reaction, an impressive earnings outlook gets more press and results in higher liquidity, which is extremely important for a small company.
When it comes to a small and relatively unknown company, most analysts don’t have a clue how to calculate its earnings and sales estimates. Often such companies are followed by less than five analysts, who gladly and blindly follow the guidance of the company’s management. The massive belief is that the management knows the most about the future perspectives of its company and its guidance should be “the best number we can get”. The point is that the management has the incentives to keep analysts’s estimates to a level that is easily beatable. As a consequence, analysts place their estimates in the middle of the announced earnings guidance range. For example if the EPS guidance for next quarter is $0.40 to $0.50, the consensus estimate will often be $0.45 or lower. In the cases, where the estimates are in the lower half of the guided range, analysts often have a buy or overweight rating for the stock. In such occasion, analysts have the incentives to be extremely conservative, so their customers won’t get caught in a stock that misses earnings’ estimates. Certainly not all analysts are lemmings. There are some quite sophisticated and highly intelligent, who do their own research and calculate their own estimates. Unfortunately the best analysts either follow the biggest and most popular stocks or after a few short years of exceptional work get promoted and go to work for the Buy side.
Remember, prices rise only when expectations rise. Expectations rise when there is a new catalyst on the horizon. The best performing stocks in any given year are the ones that manage to surprise the most in terms of size and frequency.
I have much more to say about positive earnings pre-announcements and how they should be used, but I’ll leave that for another time.