Earnings Magic Exposed

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Following the end of each fiscal quarter, SEC-registered corporations release their financial statements. Investors and the media place a lot of importance on these results. Consequently, stock prices tend to rise or fall based on how the financial results compare to a consensus of estimates made by Wall Street analysts.

Since the beginning of the current quarter (10/1/2016), 76% of the 113 S&P 500 companies that have released earnings results have exceeded expectations. Like so many quarters before, investors and media pundits are supporting the naïve conclusion that earnings were better than expected.

Unfortunately, few investors are paying attention to the measurement tool, expected earnings, to gauge its usefulness as a measure of earnings quality. In this article, we expose the crafty game that Wall Street and corporate investor relations departments play to put a positive spin on earnings releases and give the impression that stock prices are cheap based on forward-looking earnings expectations.

Miraculous results

The graph below shows that actual aggregate earnings growth for the S&P 500 has exceeded the corresponding consensus final expectation for earnings growth without fail since at least the second quarter of 2012. Not once has a quarter’s earnings (green bar) been lower than the most recent earnings expectation (red bar).

Final Earnings Expectations versus Actual Earnings

Data Courtesy: Standard and Poors

To comprehend how corporate earnings have regularly exceed respective expectations quarter after quarter, one must recognize how earnings forecasts are used to manipulate investor expectations. When one studies the trend of earnings forecasts from a year preceding the results to the weeks prior to the results, one will notice two things. First, initial earnings forecasts are crafted to tell a bullish long-term story of strong earnings growth. Second, over the course of the ensuing year, the estimates are adjusted significantly downward to temper expectations and therefore make actual earnings that fall far short of the original forecast appear pleasantly surprising.

Consider that since the second quarter of 2012, earnings growth forecasts made a year in advance averaged 14.76%. Over the same five-year period, actual earnings growth was 3.82%, or 75% below the original estimate. Of the last 17 quarters the best one-year advance estimate of earnings growth was overstated by 25%. Astonishingly, this period includes quarters when economic growth exceeded forecasts, so a worse than expected environment cannot always be blamed. The last four quarters have seen actual earnings growth (-2.70%) fall grossly short of one-year advance forecasts for growth (+14.30%) by over 100%.