In 2000, General Electric posted its 100th consecutive quarter of growth in continuing operations. That's 25 years. Raise your hand if that sounds just a bit suspicious. Whatever business you're in, that feat just isn't possible unless your company's managing its reported earnings.
According to a 1998 survey, 78% of CFOs attending a given conference said they'd been asked to "cast financial results in a better light" without running afoul of GAAP. Half said they'd done it. Nearly half said they'd been asked to misrepresent their company's numbers, and 38% admitted they'd done so. Another survey at a different conference found that more than half of the CFOs attending had been asked to juice their numbers, and 17% had agreed to do so.
It's easy to understand why companies succumb to the incredible pressure to make it look like they've met or beaten targets or Wall Street expectations. Consistent growth is a feather in any CEO's cap, and a rising stock price often increases many executives' compensation, especially from stock options. But when companies stray from merely managing their numbers within GAAP into outright fudging them -- Enron, Sunbeam, we're looking at you here -- they can ruin themselves and their shareholders.
How can we spot suspicious earnings patterns soon enough to save ourselves? We can track how closely a company meets earnings expectations, monitor its frequency of year-over-year growth, and compare those stats to numbers from a few competitors, which should be affected similarly by changes in the business cycle. Any company that lands eerily close to earnings-per-share (EPS) expectations, and grows earnings year-over-year with unusual reliability, should raise a yellow flag and invite us to look closer.
Here's a look at what Qwest Communications
Company |
Reported EPS Within $0.02 of Estimates? |
How Close to Estimates, on Average |
How Often It Reported Growth |
---|---|---|---|
Qwest Communications |
18 times in last 25 quarters. |
$0.01 |
14 times in last 21 quarters. |
Verizon Communications |
23 times in last 26 quarters. |
$0.01 |
8 times in last 22 quarters. |
Sprint Nextel |
10 times in last 25 quarters. |
($0.06) |
6 times in last 21 quarters. |
Source: Earnings.com and author calculation. Difference in number of quarters counted due to data source.
While Qwest got close to estimates much more often than not and reported growth two-thirds of the time over the past five-plus years, that's not quite enough to really raise a yellow flag for me. Keeping an eye on this metric going forward would be Foolish, but at the moment, things aren't jumping out and hollering. Verizon would have been of more worry because of the higher number of close hits, but the low number of yearly growth reports make me think it's more about managing analysts than earnings. And Sprint seems fine, at least according to this metric. As Qwest prepares to merge with CenturyLink, investors will have to keep an eye on the combined entity's reporting.
Note that I'm not concentrating on managing estimates here -- though management does that, too. However, if a management team always seems to deliver on estimates time and time again, you should probably dig a bit deeper, to see whether its interpretation of GAAP is getting a bit too fast and loose.
Investors crave consistency. That's one reason why its string of reliable results spurred GE's stock price to rise so much in the 1980s and 1990s. But the real world isn't consistent, and Foolish investors should account for that. If a company's results seem too steady to be true, Fools should proceed with caution.