Why Earnings ‘Beats’ Are Never a Surprise

by Dan Burrows | May 16, 2012 7:30 am

Why Earnings ‘Beats’ Are Never a Surprise

First-quarter earnings season is just about over, and — surprise, surprise — results came in much better than Wall Street’s forecasts. Yes, pretty much as they always do.

It’s said that the CEO of a publicly traded company’s most important job is to manage investors’ expectations. If that’s so, CEOs did a bang-up job this reporting season.

The amazing thing is that investors ever fall for it.

Sure, it makes all the sense in the world to underpromise and overdeliver, with Apple (NASDAQ:AAPL[1]) the master of this dynamic. Underpromising makes all the difference between a nasty negative surprise (with shares getting clobbered) and a happy post-earnings pop.

It also makes sense for Wall Street analysts to lowball. They take their cues from management’s official guidance, after all, and there’s no reason to stick your neck out by being too optimistic. It’s better for your career and clients to be conservative. The cost of a negative surprise and sell-off easily outweigh the benefits of an earnings beat and pop in share price.

So it’s a wonder why better-than-expected earnings are ever news since the majority of companies always beat Wall Street’s earnings estimates. In the history of the data series, the earnings-beat rate — i.e., the proportion of companies exceeded earnings estimates — is in the low-60% range, according to Thomson Reuters.

So while it’s welcome news that the widely expected poor first-quarter showing did not come to pass, we most certainly should have seen it coming. It’s also worth remembering that the scorching-hot beat rate of just a few weeks ago rapidly came back down to earth — pretty much like it does over the course of every earnings season.

As the last component of the Dow Jones Industrial Average to report, Wal-Mart (NYSE:WMT[2]) marks the unofficial end of earnings season on Thursday. But ever since Alcoa (NYSE:AA[3]) kicked things off back in April, everything has been sunshine and roses — thanks to the bar being so low that companies could trip over it.

Heading into this earnings season, analysts forecast that companies in the S&P 500 would post profit growth of essentially zero year-over-year, according to data from FactSet. Heck, it was supposed to be the weakest earnings season since the financial crisis.

But here we are with more than 450 companies in the S&P 500 having reported, and — lo and behold — earnings have climbed 7.3%. That’s nearly the same forecast analysts held at the end of the fourth quarter. So what gives? Between the end of last year and the end of March, analysts slashed forecasts like crazy — clearly, by far, far too much.

“Compared to the end of the fourth quarter, the earnings growth rate today (7.3%) is more than double the estimated earnings growth rate of 3.0% on December 31,” wrote John Butters, FactSet’s senior earnings analyst, in a report. “Six of the 10 sectors in the index have a higher earnings growth rate today compared to December 31.”

Meanwhile, the beat rate stands at 72%. That precisely matches the average beat rate of the last four earnings seasons. (Note that it’s also well below the sky-high beat rate of 81% notched in late April. The earnings beat rate typically starts high and then cools off as results pour in — yet another lesson we never seem to learn.)

Top-line results came in better than expected, too. Of companies that have reported so far, 65% beat Wall Street’s revenue estimates, slightly better than the trailing four-quarter average of 62%.

Liz Ann Sonders, chief investment strategist at Charles Schwab (NASDAQ:SCHW[4]), told clients that the beat rate reflects the fact that analysts lowered the bar too much for the quarter — and likely for the next quarter as well.

Well, yes. That’s what they do. And they are still at it. According to FactSet, Wall Street has already begun slashing its estimates for the current quarter. On April 27, the estimated second-quarter earnings growth rate was 6.2%. Today it stands at 5.4%. Soon it will come down more.

Earnings forecasts are made to be beat. It’s not really news when a company exceeds estimates — only when it misses them. Keep that in mind when the hand-wringing begins in anticipation of another “disappointing” reporting season.

Endnotes:
  1. AAPL: http://studio-5.financialcontent.com/investplace/quote?Symbol=AAPL
  2. WMT: http://studio-5.financialcontent.com/investplace/quote?Symbol=WMT
  3. AA: http://studio-5.financialcontent.com/investplace/quote?Symbol=AA
  4. SCHW: http://studio-5.financialcontent.com/investplace/quote?Symbol=SCHW

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