6 reasons why Wall Street analysts mis-estimate company earnings

companies continue to beat Wall Street estimates

It’s earnings season again.  As companies report their results for the quarter, investors watch carefully to see whether they match, surpass, or fall short of, the consensus estimates of Wall Street securities analysts.  As has been the case since the bull market began over two years ago, a majority of companies are beating the consensus figures–some by a mile .

Why don’t analysts do a better job of forecasting?   

I have six reasons (five of them today, the final one tomorrow):

1.  Some companies are very hard to forecast, because they’re so complex.  They may have a lot of divisions, many suppliers and a large variety of finished products that they sell.   

Alcoa, the first of the big publicly traded US corporations to report each quarter, is a case in point.  You’d think that the main variable for Alcoa would be the price of aluminum, which you can see every day in commodities trading.  …but no.

Alcoa can get its raw materials from many sources.   Some sources are joint ventures that Alcoa’s a part of, which often have complicated profit-sharing arrangements that are not publicly disclosed.

Miners deliberately change the grade of ore they mine, depending on price, to maximize the life of the ore body.  Ore can be processed in different locations, some company-owned, some not, depending on the price of electric power and other factors.  So expenses are hard to gauge.

On top of all that, differing accounting conventions at each step of the way can play a big role in what cost figures eventually appear on the income statement.

In a case like this, it’s hard to imagine anyone outside the company having a good handle on what reported earnings will be.

2.  Some companies demand that analysts stay close to “official” guidance.  CEOs understand that having earnings per share that exceed the consensus is a good thing for their company’s stock  (a positive earnings surprise), and that missing the consensus can be a very bad thing  (a negative surprise).  So most firms that issue next-quarter guidance to analysts give out numbers they believe they have an excellent chance of beating.

Some firms go further than that.  They make it clear they will punish any analyst who deviates from guidance more than a little bit.

What can a company do?

Lots of bad stuff.  From descending order from worst to not-as-bad, the company can:

–stop using the analyst’s firm for any investment banking services, like underwriting debt or equity offerings (which is likely to get the analyst fired),

–not appear at industry conferences the analyst’s firm may organize, or send the investor relations guy instead of the CEO or CFO,

–avoid using the analyst to organize the company’s visits to powerful investment management companies,

–refuse to give the analyst access to top company officers to ask questions about operations,

–delete the analyst from the queue to ask questions during earnings conference calls (petty, it’s true, but not unusual).

There have been cases of stubborn analysts who have stuck to their guns in print, against company wishes.  Their stories  usually end badly.  For most, they’ll show the number the company wants in their written reports and “whisper” their best guesses to clients.

3.  Some analysts aren’t good with numbers.  That’s not always a fatal flaw.  The analyst may have other pluses–a deep knowledge of the inner workings of an industry, an ability to  sense new trends quickly, or very good contacts with the companies, or customers and suppliers.  Or maybe they just know where to take clients to lunch.  After all, when you get down to it, sell-side analysts are paid for their ability to generate commission business  for their trading desks and to attract/keep investment banking clients–not necessarily for having the best numbers.

4.  Sometimes analysts don’t do the spreadsheets themselves.  An assistant does them instead.  Analysts may spend half their time on the road visiting companies and clients.  Much of the rest of the time, they’re doing the same thing on the phone.  And the analyst may not be so great with numbers, anyway.  So that task is relegated to an assistant.

An aside about assistants:  in my experience, many analysts pick assistants who are articulate, look good in a suit and are smart–but not too smart.  Why?  A sell-side analyst may earn 10x-20x what an assistant does, in an industry that suffers a severe downturn in profits about twice a decade.  The analyst may worry that having a top-notch assistant means the analyst becomes a cost-cutting victim during recession.

5.  Many experienced analysts have been laid off over the past few years.  Doing good estimates doesn’t require a genius, but it does require some training and experience.  A lot of that has been lost on the sell sidesince the Great Recession began.  In addition, as I suggested above, the assistants who have been promoted into the principal analyst jobs may not all be the brightest crayons.

That’s it for today.  I’ll write about #6, making really dumb mistakes, tomorrow.

Looking at inventory (II): figuring operating leverage

Analysts get information from company financials by comparing two or more sets

Even if a company’s financial statements have an almost photographic fidelity to the structure and inner workings of the enterprise they represent, it’s very difficult for the outside observer to understand what is being portrayed from one set of financials alone–unless, of course, the company is in disastrous financial shape.

Instead, the analyst gets his information from comparison of two or more sets of financials, preferably covering relatively short periods of time, with one another.  In many ways, sequential quarters are the best, since there is the smallest lapse of time between the observation points.  For companies with significant seasonality in their product mix, however, comparison of year over year quarters will produce the fewest distortions.

Question #1:  is there leverage?

One of the first and most basic question you should ask yourself about a company you are starting to look at is whether it has either financial or operating leverage.  A company with leverage is one where a change in revenue produces disproportionately large changes in operating income.  Leverage comes in two types:

Financial leverage comes from a company’s capital structure.  The idea is that a company that uses debt to finance expansion will produce higher returns on equity as long as the operating profits produced by expansion are higher than the interest expense on the borrowings.

You can do the calculations yourself, but publications like Value Line have statistical arrays that do the work for you.  Look at the lines for “Return on Capital” and “Return on Equity.”  If the numbers are different, the company has financial leverage.  Hopefully the returns on equity are higher than the returns on capital (debt + equity).  That’s the way it’s supposed to work.

Operating leverage, which comes from the operating structure of the company.  Firms with operating leverage typically have high fixed expenses of maintaining a manufacturing (or service) operation, but low variable costs of making each unit sold.

FIFO companies

For a company that uses FIFO accounting (see the first post in this series), finding out the operating profit on an incremental unit of production is easy.

1.  Take the revenue figure for the more recent of the quarter you’re comparing and subtract from it the revenue for the more distant quarter in time.  That gives you incremental revenue.

2.  Do the same for the two operating income figures.  That gives you incremental income.

3.  Divide incremental income by incremental revenue and you get an incremental margin.

4.  Compare this figure with the operating margin for either of the two comparison quarters.  If the incremental margin is larger than the average margin for the quarters, the firm in question has operating leverage.  And, if so, you know that in forecasting future quarters, incremental revenue will earn the incremental profit margin.  Therefore, even small increases in revenue can produce positive earnings surprises.  Conversely, even small revenue shortfalls can produce earnigs disappointments.

LIFO companies

For a company that uses LIFO, however, the situation isn’t as straightforward.  Under LIFO accounting, every quarter after the first can be a kind of mid-course correction to the estimates the company employed in arriving at first-quarter cost of goods.

I think it’s reasonable to assume that a company uses a consistent estimating methodology from one year to the next.  If the company chose last year to add in a little safety margin for earnings later in the year by making a high initial estimate for cost of goods, then it’s a good bet that they’ll do the same for this year.

Therefore, it’s a pretty safe assumption that we can analyze incremental margins using the first quarters of two consecutive years.  In any event, it’s the best we can do.

On the other hand, we take a real risk if we use second through fourth quarters by themselves in a year on year comparison.  We can’t rule out the possibility that they’re just residuals left from the re-estimating process.  But we can use (Q1 + Q2) of the current year vs (Q1 + Q2) of last year to do the incremental calculation described in the FIFO section above.  Similarly, we can use Q1 + Q2 + Q3 or the full year as our comparison base.

For the same reason we should hesitate to  use Q2, Q3 or Q4 alone, we also probably shouldn’t use sequential quarters to do the calculation.

For a professional securities analyst, it may make sense to do quarterly year on year or sequential comparisons for a LIFO company anyway.  If you look at enough years, you may find that there’s a consistent pattern to the LIFO adjustments, so you can anticipate with the company is likely to do in the coming quarters.  Even if there isn’t, you may learn enough to make this a topic of conversation with the company’s management.  If someone is willing to take the time to explain how they approach LIFO estimates, you’ll doubtless learn a lot of things from the explanation that you’d never have thought about otherwise.

Looking at Inventory (I): general

Two posts

I’m going to cover this topic in two posts.  This one will be about what inventories are:  the sub-categories of the inventory entry on the balance sheet, and three main ways companies choose to account for inventories.  Tomorrow’s post will cover what kinds of information you can get about a company from comparing the inventory entries from different time periods.

Here goes:

There are three sub-categories of inventory on a company’s balance sheet:

raw materials.  This is pretty straightforward.  Raw materials are inputs to production that the company owns but has not yet begun to process.  They might be a pile of iron ore outside a steel mill or a bunch of windshield wipers stacked in a warehouse next to an auto assembly plant.

This entry records what the company owns, which may be something very different from what’s at the production site.  The idea of “just in time” manufacturing is that the component suppliers have warehouses full of their wares that they deliver on the day they’re needed.

In today’s world, financing cost aren’t the big issue.  Instead, it’s who takes the risk that the stuff in the warehouse falls in price while it’s just sitting there.  The answer is whichever party has less market power, typically the component supplier.

work in process (which a lot of people incorrectly call “work in progress”).  This is stuff that has entered production and is in the process of being turned into finished goods.  The increase in value of the raw materials will be a mix of direct costs involved in making the item, like salaries of assembly workers, and indirect, or period costs, like the cost of renting/leasing the production site, utilities (heating, lighting), and salaries of foremen and the plant manager.

The amount of work in process varies widely from industry to industry.  Assembly of a PC or a cellphone may take a day.  A semiconductor may take several months.  Wine or whiskey may ferment for years.

finished goods.  This one is also straightforward.  It’s the final products a company makes that are waiting in storage for a buyer to pick them up–or in some cases, to materialize in the first place.

How finished goods move from the balance sheet to the income statement Continue reading