How Good Are Earnings Really?

One of the strongest issues in the perma-Bull’s arsenal has been the 16 consecutive quarters of double digit year-over-year earnings growth.

My reservations about earnings have been twofold: First, SPX gains have been unusually reliant on energy and materials stocks, accounting for a disproportionate (by some measures, as much as half) of earnings improvements; Given the drop in oil, copper, steel, etc., (at least short term), these companie’s contribution to S&P profitability are likely to feel some impact. (Longer term, I remain bullish on the Oils). 

Secondly, financial engineering of year-over-year earnings continues via share buybacks. About a third — 5 of the 15% E gains — are due to the massive stock buybacks we have seen. According to Merrill Lynches David Rosenberg, this has reduced share count to the point of improving earnings by that third.

Now, there is another earnings issue worth looking at: Expectation-Management:

"Stephen Biggar, director of American equity research at Standard &
Poor’s, questions the reliability of those estimates. In the weeks
before an earnings announcement, Mr. Biggar said, companies often talk
down their prospects so that analysts reduce estimates, making the
actual numbers sound better. He prefers to compare reported earnings
with estimates made before the expectation-management exercise begins.
Using estimates in place on Sept. 18, he concludes that companies are
not doing as well as many people think.

Of 68 S.& P. 500 companies that have reported third-quarter results, 41 failed to meet the September estimates for operating earnings, he said. The median shortfall was 4.3 percent. But 74 percent of companies in the S.& P. 500 that have reported so far exceeded the latest estimates and only 8 percent undershot them, according to Thomson Financial."

In the final month of the quarter, companies do some "fancy footwork" to bring down estimates. They restate earnings from previous quarters, making the present growth seem more robust, according to Mr. Biggar. "There is a penchant by companies to make this year’s number look good but to make last year’s number look bad," he said.

The reality check? Investors need to scrutinize earnings reports carefully: "A lot of these companies that say they’re 11, 13, 14 percent growers are not," he said. "It’s difficult to have confidence in the numbers they’re reporting."

UPDATE October 24, 2006 3:45pm
Here’s a chart of Third Quarter Earnings and Guidance changes via Birinyi Research —




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