Investors often eagerly await a company's quarterly and annual earnings reports, eager to see whether they will "beat" or "miss" analysts' expectations. However, as some experienced investors and financial analysts will tell you, these beats or misses may not provide as much valuable information as one might think. In reality, they are often overemphasized in the investment community and can lead to short-term overreactions. This article will explain why earnings misses and beats can often be meaningless metrics, due to the constant adjustments that financial analysts make to their estimates.
Analyst Estimate Adjustments: An Endless Cycle
To understand why an earnings miss or beat can often be a misleading metric, one must first understand the process by which financial analysts formulate their estimates. Financial analysts use various models and assumptions to predict a company's future earnings. These models are not static; they are constantly revised based on new information. For instance, if a company releases a new product, or if economic conditions change, analysts will adjust their estimates to reflect these developments. The problem with this continuous revision is that it often results in a moving target for the company's earnings. Suppose a company is predicted to earn $1.00 per share for the quarter. As the quarter progresses, suppose the analysts revise their estimate downward to $0.90. If the company eventually reports earnings of $0.95 per share, it will have "beat" the revised estimate but missed the original estimate. In this scenario, has the company performed well or poorly? The answer is subjective and depends on the perspective.
The Apple Inc. Case: Let's take a real-life example from Apple Inc. (AAPL). In the first quarter of 2019, Apple reported earnings that beat Wall Street estimates, and its shares jumped by over 5% after hours. However, what was not mentioned in most headlines was the fact that analysts had lowered their earnings estimates for Apple by about 13% over the quarter, according to data from FactSet. So, while Apple beat the reduced expectations, it would have missed the original estimates set at the beginning of the quarter. This example illustrates how earnings beats and misses can be misleading metrics for investors.
The Tesla Inc. Case: Consider a more recent example from Tesla Inc. (TSLA). In the second quarter of 2023, Tesla reported earnings that surpassed Wall Street estimates, and its shares surged by over 7% in after-hours trading. However, what was not highlighted in most news reports was the fact that analysts had reduced their earnings estimates for Tesla by approximately 15% over the quarter, according to data from FactSet. So, while Tesla exceeded the lowered expectations, it would have fallen short of the original estimates set at the beginning of the quarter. This case demonstrates how earnings beats and misses can provide a skewed perspective for investors.
Market Reactions and Short-Term Noise
The constant adjustment of analysts' estimates can lead to knee-jerk reactions in the stock market. When a company reports earnings that beat estimates, its share price often rises, at least in the short term. Conversely, if a company reports earnings that miss estimates, its share price often falls. These short-term price movements, however, can often be misleading. They are more reflective of the market's reaction to the earnings report relative to expectations rather than an objective evaluation of the company's performance.
Long-Term Performance Matters More
Rather than focusing solely on whether a company beats or misses analyst estimates, investors should focus more on the company's long-term performance. Key metrics such as revenue growth, profit margins, return on equity, cash flow, and debt levels provide a more comprehensive picture of a company's financial health. An earnings beat or miss can be influenced by many factors, including changes in accounting rules, one-time items, and adjustments by analysts. Moreover, the quality of earnings is also important. Companies can use various accounting techniques to manipulate earnings and achieve an earnings beat. If the earnings beat is driven by high-quality earnings - for example, through increased sales or improved operational efficiency - that's a positive sign. However, if the earnings beat is due to a one-time item or accounting manipulation, it may not be sustainable in the long run.
While earnings beats and misses often grab headlines, they are not the most reliable indicators of a company's performance. The constant adjustment of analyst estimates often creates a moving target for earnings, which can lead to misleading perceptions of performance and short-term market reactions. As an investor, it's crucial to focus more on long-term performance metrics and the quality of earnings to make informed investment decisions.