Do you think you have a potential investment that’s growing its profits and sales. Great! But is it growing fast enough? After all, most people expect Apple to do well. It’s not exactly news that the company has a hit gadget and will be selling more iPads next quarter or next year.
But how many more … well, that’s up for debate.
This is the slipperiest part of all. Wall Street prices stocks based on what they are going to do in the future, not what they’ve already done. A company’s profits might jump by 25%, but if investors were expecting 50% gains, shares will crash. On the other hand, a sleepy company forecasting a measly 5% growth could explode higher if it posts 25% growth instead.
Confusing, I know. But remember this: Picking the right stocks is all about expectations.
How Can You Check up on Expectations?
This is the first real area where it becomes clear how much of a disadvantage individual investors have. Even if you are retired, you likely don’t have the inclination to pore over countless company filings with the SEC and make your own projections. Why spend hours researching fluctuations in European sales or calculating how profit margins will be affected by a 5% rise in the price of corn when you have grandkids to play with?
But take heart! What you do have is the Internet, and the wisdom of crowds. That allows you access to the opinions of Wall Street investment banks already doing that work and publicly sharing their findings.
My strategy is to ignore the actual figures people are forecasting and instead focus on the direction of the forecasts. That is, if they were expecting earnings of $1.50 per share this quarter last month, are they expecting $1.75 now — or $1.25?
In a nutshell, if forecasts are moving up I take that as a good sign because people keep setting the bar higher. If they are moving down, expectations are fading, which is cause for concern.
Forecasts might sound difficult to find, but they’re not. Just go to Yahoo! Finance and type in the ticker of your stock of choice, as usual. Click on “Analyst Estimates” in the left rail and then check “EPS trends” to see what’s up.
Notice this view of Apple estimates. Notice for almost every successive time period, revisions continue to move higher. That is an encouraging sign. The average earnings estimate for a given stock is almost always a moving target — but it’s an undeniably good thing to see that target moving up.
What’s the History of the Company in Regards to Expectations?
It’s also valuable to look at how the company fared against forecasts in recent history. Some companies have “beating the Street” down to a science, carefully controlling optimism and then impressing investors with their results. Others are all over the place, and Wall Street frequently is very surprised or very disappointed, causing the stock to gyrate in price.
As the saying goes, past performance is no guarantee of future returns. But it’s worth at least looking into the consistency of a company’s performance on the earnings front. And thanks to Yahoo! Finance, it’s also incredibly easy to find this, too.
Again, click on “Analyst Estimates” in the left rail. This time, look under “Earnings History.” You’ll find the forecast for each of the past four quarters, the actual earnings per share reported and the percent by which a company missed or exceeded expectations.
A long track record of earnings beats is no promise of another great report in the quarter to come. But it’s certainly something to note.
More importantly, however, is a long history of earnings misses. The ugly reality is that the majority of stocks — or more than 50% of the S&P 500, according to research — have beaten Wall Street expectations every year since the third quarter of 1998! For a variety of reasons, analysts are trained to set the bar a bit low for their corporate overlords.
So if a company has a history of mediocre performances, it’s a bit of a concern. And missing expectations obviously are very disturbing.
Think of it this way: The earnings tests administered by Wall Street are often designed to be pretty easy. A company that gets C’s or D’s looks bad enough — but when you consider how unimpressive the test is, it makes poor performance all that more disconcerting.
Check out a complete list of Investing 101 articles by Jeff Reeves for more on learning how to invest and pick stocks.
Also, for just 99 cents you can download Jeff’s e-book “The Frugal Investor’s Guide to Finding Great Stocks: 11 Free Resources to Help Beginners Identify Fantastic Investments.”
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