Vegas Meets Wall Street: The Consensus Earnings Estimates Game
By Aman Raina, AKR Capital Research

"Intel has just reported its 3rd quarter results. They came in at $1.17. The consensus estimate was for $1.10 seven cents ahead of expectations. It looks like they beat the number…"

Congratulations!! Your stock just reported higher earnings! You sit back and prepare yourself for the stock to surge. Ah! the dream of buying that big screen TV is looking pretty good right now, but alas your stock falls. Sorry, those higher earnings were below the "consensus estimates". You have just played the Earnings Estimates game.

This has become the norm in earnings announcements. Earnings accompanied by a benchmark, that apparently indicates whether a company is meeting the market’s expectations. The "market" in this case is a cartel of analysts, economists, and soothsayers that apparently have a better idea than the company itself on how a firm should be performing despite the fact they have never owned or operated a similar business. Essentially the "consensus" is nothing more than a glorified bookie that sets the odds. The stock market has always involved an element of gambling. Now it is more legitimized. If you are the CEO of one of these companies it isn’t about being profitable anymore. It is all about beating the "odds" or "beating the number, " or more appropriately "beating the house". This obsession with consensus estimates has forced managers to think more about how to tailor their financial statements to appease the cartel and less about making sound business decisions that are in the best interest of the people that count, the shareholders.

Which leads to the question of the number itself. How do these estimates get derived? Is it the "I’m thinking of a number between $2.00 and $2.50 per share" model of investment analysis? As my math teacher always said, "where’s the work?". First Call, the firm that "sets the odds" for earnings estimates shows the consensus EPS, but no real detailed explanation on how they got the number. What accounting or financial assumptions are they applying to their estimate? The most common assumption that is evident is that if the firm’s earnings increased 40 percent the previous year, then it will increase 40 percent per year for eternity. It’s hard enough to forecast the weather, how can you forecast what a firm will make 3 years from now? How many times have we seen analysts reduce their revenue projections downward due to overestimation because they assumed the company has been growing x percent historically, that it will grow x percent indefinitely. The analyst never admits his failure. It is obviously the companies fault for not giving full disclosure. It’s ironic that public companies when issuing financial statements have to comply with Generally Accepted Accounting Principles and must follow a sea of accounting rules and standards for disclosure with fear of recrimination by the regulators, yet analysts have no real requirements for disclosure. They can just throw a number in the hat and see what happens. The cartel is above that. How do we know that one of the members of the cartel simply had a bad encounter with the company at an analysts meeting (The cartel has their own meetings by the way) and proceeded to downgrade the stock. They didn’t like the shrimp salad or the bagels were too dry or something trivial. Sounds stupid?. Ask shareholders of Boston Chicken who saw their stock get downgraded not because of earnings, but because an analyst didn't get the red capet treatment at a analyst conference call.

This is why I think the EP model brings us back to economic reality. It forces you examine if the company is truly managing its shareholder’s capital effectively. Yes the EP model is a benchmark, but unlike the consensus EPS estimate which is easily manipulated, the EP benchmark is clean of accounting distortions and it revolves around one key factor to wealth generation. Generate returns on capital that exceed the cost required to obtain that capital.

I’m not knocking the concept of a benchmark for placing a company’s financial performance in context. I guess its a human quality to compare something to another, however when sound business judgement and strategic planning are compromised just to achieve a benchmark, then it is time to ask questions. It isn’t about investing anymore. It’s about beating the spread and if that is the trend then I like my chances better in blackjack than the stock market.