Are You Playing the Stock Market’s Favorite Game?
By: Shikhar Aggarwal
Tags: Momentum Trading, Investing, Earnings Per Share, Money Management, Stock Market

Photo by Chris Liverani on Unsplash

One of the most popular questions that a business channel anchor or an analyst asks a company’s management is — “What’s your EPS estimate for the next quarter and year?”

For those who are not aware, EPS is the short form of ‘earnings per share’ and is calculated by dividing a company’s earnings/profits by its total number of shares.

During my initial days as a stock market analyst, even I was guilty of asking similar questions about earnings, though all I wanted to hear from the managements was their long-term outlook (like for 3–5 years) and not for the next quarter or year.

The truth is that the entire investment community is undeniably fixated on the EPS.

All business newspapers, magazines, channels, and experts freely talk about quarterly earnings, EPS growth, and price to earnings multiples.

The interesting part is that the stock market also reacts to the earnings numbers.

Anyways, people’s fascination with earnings estimates is not terribly puzzling. In fact, it is perfectly rational in a market dominated by agents responsible for other people’s money but also looking out for their own interests.

But what such obsession with earnings does is that it leads investors to believe that this one number strongly influences, if not totally determine, stock prices.

This is despite the fact that EPS is not the most appropriate number to use for valuing a company.

There are several shortcomings of earnings, like:

Earnings do not show whether the company is utilizing its capital profitably or not. Earnings exclude the incremental investments that a company makes in its working capital and fixed capital that are so important to support its growth. Different companies can use different accounting principles to calculate earnings, so a comparison cannot be drawn between two companies. It is easy for companies to manipulate earnings by either inflating revenues of deflating expenses.

However, notwithstanding these shortcomings of earnings, most experts love playing the earnings expectations game.

The fact is that it’s just the wrong expectations game to play.

A Game of ‘Winks and Nods’

It is hoped that the case for the unreliable link between short-term earnings and shareholder value is sufficient to discourage investors from participating in the popular earnings expectations game. This is simply because it is the wrong expectations game for investors who seek superior long-term returns.

This is true not only because of the shortcomings of earnings but because of the way the game is played.

The earnings expectations game is simply a ritual dance between management and analysts.

In fact, the former chief of the US stock market regulator Securities and Exchange Commission (SEC) Arthur Levitt called it a ‘game of winks and nods’.

In Expectations Investing, the authors Michael Mauboussin and Alfred Rappaport write:

“Analysts have to guess how much a company will earn each quarter. But a company is allowed to provide the analysts with clues, or so-called guidance, about what is thinks earnings will be. This guidance number usually shows up as the consensus estimate among analysts. If the company’s actual earnings meet or just beat the consensus, both the company and the analysts win: the stock goes up, and everyone looks smart. The game might not sound so hard, but it requires a lot of cooperation. Companies are under enormous pressure to achieve the consensus earnings estimates while analysts rely on those same companies to help them form their earnings expectations in the first place.”

You might wonder how companies participate in this game.

Well, companies generally have two ways to play it out.

One, to manage the expectations of investors and stock market, companies guide analysts to a number that they can beat. And two, in order to beat expectations easily, they are very conservative with respect to their near-term prospects.

In simple terms, a company would feed the analysts by telling them that they expect to earn $ 100 as EPS or earnings per share in the next quarter.

Analysts would take this number, do some calculation around it, and arrive at their own expectation of an EPS number that is somewhat close to $100. They would then feed the market and investors on this expected EPS number, say $95 per share.

The market and investors would then start to believe this number.

Then, when the quarter ends and the company releases its earnings report, it would say that its EPS during the quarter stood at $100 per share.

Remember, this was the same number they had revealed to analysts earlier, which the analysts had chewed to spit out the $95 per share number to investors.

Now, since the company has announced $100 EPS against the market’s ‘expectations’ of $95, the analysts call it an ‘outperformance’.

The ultimate result is that investors also start to take this as an outperformance and are willing to pay a higher price for the stock. The stock rises.

You got the game, didn’t you?

Anyways, there might be a case when this company faces a situation where investors are expecting a higher EPS (say $110), and it finds it difficult to earn that much during the quarter.

What it can do in such an instance is simply use some accounting tricks to achieve that magical EPS number of $110, and thus ‘meet expectations’.

Now the question is — How involved and interested are managements in this earnings expectations game?

Well, here is what a Harvard Business Review report that throws light on this…

Privately, corporate chief financial officers admit that they would like to spend less time and effort satisfying Wall Street’s demands for continuous, predictable growth. But they feel they don’t have much choice, because the cost of disappointing the Street is so high.

You see, the quarterly earnings management has become a sort of talisman for companies and those who analyze them, invest in them, or audit them. However, the fact remains that this game causes more harm than amusement.

When managers are focused on meeting or beating short-term earnings expectations, it distorts their decision making. A large part of the management’s attention is focused on keeping the analysts and markets happy.

What is more, a lot of companies willingly borrow profits from the future to make things look good in the present (how they do this is a subject of another discussion).

This entire scheme also reduces stock analysis and investing to a guessing contest. A large part of a stock analyst’s job is just to keep figuring out what the sales, or expenses, or simply profits are going to be in the next 1–2 quarters.

Ultimately, it undermines the faith that most investors have on the stock market because, every quarter, they are served some fiction, and become part of the cynicism that surrounds the meeting or beating of expectations.

Play it Safe!

Just notice the next time companies announce their quarterly results. You will find most of them either meeting expectations or beating expectations!

But now you know how this entire game of ‘earnings expectations’ is fixed. What you can do to safeguard yourself against the fixers is to separate companies that are genuinely working towards better long-term performance from those that skillfully manage short-term expectations and earnings.

And how do you do that?

Just stick with companies having good businesses, safe balance sheets, and clean managements at helm.

Always remember, there’s a great appeal in the word ‘earnings’. So you have to be very-very careful and not fall into the earnings expectations trap.

In fact, here’s a new definition of EPS that you can start using from today. It’s Expectations Per Share…and the wrong kind of expectations!