Something's Fishy in Many Earnings Reports

Something strange happened last month, when Apple (Nasdaq: AAPL  ) reported its quarterly earnings: They fell short of Wall Street's expectations. That has rarely happened in recent years, and the stock sank on the news, down about 7% initially. The episode was a good reminder that many companies have set us up to expect them to beat expectations -- and that bad things can happen when they don't.

The technology realm includes many frequent exceeders. For example:

Company

Times Beating Estimates in Past 12 Quarters

Times Beating Estimates in Past 20 Quarters

Apple 11 19
Brocade Communications (Nasdaq: BRCD  ) 11 19
Intel (Nasdaq: INTC  ) 10 16
JDS Uniphase (Nasdaq: JDSU  ) 10 16
Qualcomm (Nasdaq: QCOM  ) 10 16
Western Digital (NYSE: WDC  ) 10 18
Xerox (NYSE: XRX  ) 11 16

Data: AOL / Thomson Reuters.

Something fishy
It might seem unsurprising that some companies tend to exceed expectations in earnings seasons, and that other companies don't. It might seem natural. Research last year by Joseph Grundfest and Nadya Malenko of Stanford suggests, though, that something fishy might be going on.

They studied about half a million corporate earnings reports released over 27 years, examining earnings not down to the penny, but to the tenth of a penny. And they discovered that there wasn't a very even distribution of numbers. The number least represented: four-tenths of a cent.

As The Wall Street Journal noted, "Computer maker Dell didn't report earnings per share with a '4' in the 10ths place between its 1988 initial public offering and 2006. The likelihood of that happening by random chance is 1 in 2,500."

Think about the odd paucity of four-tenths, and you might see the most obvious explanation: If a company can get its earnings to hit 0.5, then that number will be rounded up to the next highest penny. In other words, earnings of $0.264 are less desirable than $0.265, because the former will be reported as $0.26, while the latter will become $0.27.

Why fiddle?
That little penny of a difference can be a big deal in a system that rewards companies that beat expectations. Such companies draw the admiration and interest of investors, while companies that disappoint can lose supporters.

Many have long suspected that companies may be fudging their earnings a bit, but this research makes it more than mere speculation. At his respected blog, The Big Picture, noted market observer Barry Ritholtz found it interesting that The Wall Street Journal chose to report on this kind of important study on a Saturday, when its readership isn't at its highest. The corporate world would probably prefer that we not think about this topic too much. Ritholz opines, "[M]any firms manage their earnings, pulling all manner of shenanigans to beat the street."

Managing earnings or cooking the books?
"Managing earnings" is a classy way to refer to how companies turn those fours into fives or beat expectations. In some cases, "cooking the books" is more fitting.

One simple way for companies to improve their lot is with the "guidance" they provide to Wall Street analysts. After all, the expectations to beat are ones that these analysts come up with based on projections from the companies themselves.

Another way is to tweak the actual earnings, which can be done in ways consistent with Generally Accepted Accounting Principles (GAAP) or in more shenanigan-like ways. For example, companies can choose from several different ways of depreciating assets, which affect earnings in different ways. How revenue is recognized is another opportunity for creativity. Revenue is supposed to be recognized when it's earned, but some companies have put it on the books as soon as a contract is signed and long before any deliverables are delivered. To smooth out earnings, some companies have kept a sum of them in a reserve account, drawing from it as needed. There are many possibilities.

What to do
If all this is alarming you, take a deep breath. It needn't derail your investing. In particular, just because companies consistently beat expectations, that doesn't automatically mean they're doing anything shady or otherwise questionable.

Here are some key points to keep in mind:

  • You can avoid this whole issue by just ignoring earnings estimates. Focus instead on how a company is doing and how its reported numbers are improving or declining. Look at actual numbers, not estimates.
  • Understand that earnings can be manipulated, not only in unacceptable ways, but also acceptable ones. Consider focusing more on other numbers, or at least adding other numbers to your mix -- such as revenue, free cash flow, operating income, cash from operations, and so on.
  • Remember that even though a company may take a hit for missing its estimate, it may recover soon after that, unless there are major problems. In addition, as long as you're invested in a company for the long haul, how its stock moves over a particular week or quarter isn't too meaningful. What matters is where the stock price is some years down the road.

Companies that manage earnings aren't necessarily to be avoided -- many have been terrific wealth-builders for many years. Just invest with your eyes open.

Looking for some promising investments? Read this free report from The Motley Fool to find the names of five stocks we own that you should, too.

Longtime Fool contributor Selena Maranjian owns shares of Qualcomm, Apple, and Intel, but she holds no other position in any company mentioned. Check out her holdings and a short bio. The Motley Fool owns shares of Western Digital, Qualcomm, Intel, and Apple and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Dell, Intel, and Apple, as well as creating bull call spread positions on Intel and Apple. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 10, 2011, at 5:58 PM, Klippenstein wrote:

    Thanks not the half of it. Look at how many tech companies take after tax earnings and use them to buy back stock they "gift" to employees that same year. As Warren Buffett has argued many times, these option are effectively salaries and should be expensed. Intel, for example, spends about $5 billion of after tax earnings annually to buy back stock it has granted to employee's via stock options. In rare (and wonderful!) contrast, Microsoft's stock awards are fully expensed over the 4 or 5 year vesting period. What does this mean? Microsoft's earnings are real whereas Intel's are inflated.

  • Report this Comment On November 11, 2011, at 1:38 AM, beerandcandy wrote:

    intel doesn't give out stock options any more

    i think the last time they did was 4 years ago or something like that

  • Report this Comment On November 11, 2011, at 1:47 AM, beerandcandy wrote:

    no intel people have been able to use options since 2001 they have been underwater

    so if intel is spending 5 billion to buy stock then that means the stock is worth more now and what does earnings are real while the other is inflated mean anyways intel has higher earnings?

  • Report this Comment On November 11, 2011, at 2:32 AM, KurtEng wrote:

    How did they compute that 1 in 2,500 chance of Dell not reporting a 4 in the tenth of a cent placeholder? There were 19 report from 1988 to 2006, so the chance of never reporting a given number in any place is 0.9^19=0.135 or 1 in 7.4. it is also highly suspicious that they stop their calculations in 2006. Did they report a 4 in 2007? I have trouble reading after that funny piece of mathematics.

  • Report this Comment On November 11, 2011, at 1:30 PM, DividendsBoom wrote:

    .9^(19*4) there were 4 quarters each year.

  • Report this Comment On November 11, 2011, at 3:32 PM, duane1x wrote:

    Ultimately a sell side message wrapped in a beware title. Something's fishy! But if you buy for the long term, you'll be okay.Final sentence: "what matters is where the stock price is some years down the road."

    Note the indeterminate "some years." It's interesting to frame this idea with a table of tech companies, many of whom were high flyers during the dot com era. It's unlikely you would ever have bought Brocade, or JDSU, at any point in the mid to long term, and come out okay.

    Looking at that list, I would have picked Intel as the most stable franchise, but even Intel is a loser from 10 years ago, and a substantial loser from the peak. Dividends included. Where is the bullet point for that?

    Glancing thru the charts ironically for me it's Western Digital that you would have had the most chance of long term success. You'd be in the green on WDC if you'd bought in all but two of the peak years 1996 and 1997. I don't remember the history of WDC but for some reason it came down to earth before the general dot com bust. Still, if ever a list showed you the perils of trying to buy stock for even mid or long term gains, it's this list.

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