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First off, what do we mean when we talk about an "earnings estimate"? Put simply, this is the number that analysts working for money managers or investment bankers come up with to approximate a public company's revenues and profits for the next quarter and for the next couple of quarters. Analysts will also usually come up with forecasts for the company's entire current fiscal year and following fiscal year. Estimates are usually expressed as earnings per share, or EPS. This is a company's net income (the money left over after all expenses and taxes have been paid) for the quarter divided by the average number of shares outstanding for that quarter.
For example, Cisco's (Nasdaq: CSCO) net income for the three months ended January 29, 2000 was $825 million. It had shares outstanding for the quarter totaling 3.648 billion. Therefore, Cisco's EPS for that quarter was $0.23 ($825 divided by 3648).
Analysts derive their earnings estimates for companies through financial modeling. This involves the analyst looking at the company's financial history (through documents like SEC filings), future prospects, and the state of the industry the company operates in. Analysts also may look at the financial history and prospects for the company's competition, as well as trends in the economy as a whole. They then draw conclusions about the possible future growth rates for the company. After they develop their assumptions, analysts plug the assumptions into their mathematical models to give them the projected earnings numbers.
After an analyst has spent the time to develop his estimates for a company, he'll want to know if he's close to what the company expects. A good analyst is an accurate analyst, though the definition of "accurate" can sometimes vary, depending on the analyst's firm's relationship with the company in question.
The analyst will often send his estimates to the company for review and guidance. He'll also compare the results of his analysis to the estimates from other analysts. Different companies have different policies as to how they respond to analysts. Some will provide lots of feedback, making comments on almost every line in the model (revenue, cost of goods sold, marketing expense, administrative expenses, etc.). Some simply focus on the bottom line: "Well, that EPS number of $0.42 may be a little high." Others will only point out egregious errors, while a few (usually the ones that don't need to raise equity capital) won't comment at all.
Now, it's right here that things can get a little sketchy in the land of earnings estimates and guidance. In a market environment where beating earnings estimates is the Holy Grail for companies, and executives (and shareholders) have come to expect a pop up in stock price as a result of it, guiding analysts becomes more and more lucrative. This is short-term thinking, but oftentimes companies feel more beholden to the whimsy of headlines proclaiming that they beat estimates than they do honest exchange with an analyst (or long-term thinking for their shareholders).
It's counter-intuitive in some ways, but when a company's business situation and stock price are strong, it might want the estimate lowered -- to allow the company to eventually beat the estimates. And who doesn't love it when a company they own "surprises the Street"? Sometimes companies may want the estimate lowered to ridiculous levels, just so that they can be certain to beat them with a vengeance. Microsoft (Nasdaq: MSFT) is an example of a company that has guided analysts lower on several occasions, and then comes in with earnings that make the estimate look silly.
On the other hand, if the stock price has been in trouble, but the business is still strong, a company may actually want the estimate raised (and they'll want concurrent press saying that the estimate was raised). This shows the Street promise in the company and a future that looks solid. Maybe it'll get an increase in its stock price as investors see this news and say to themselves, "Hey, things must not be going so badly over there, if analysts are raising estimates on the company!" (This is an especially tricky strategy, though, as the company must make sure it will meet those raised expectations -- or else the stock price could end up right back where it was.)
There are times where guiding analysts to change an estimate is justified. No one knows what's going on inside a company and inside the company's industry better than the company itself. Maybe an analyst really has missed a key business trend or change at the company. Maybe the analyst really is assuming too much in his projections for the company's growth. In these cases, guiding and informing the analyst is valuable. However, for the most part, guiding estimates has become a game driven by short-term thinking.
Why would an analyst listen to the company? Why would an analyst who has worked hard to come up with the correct assumptions and numbers kowtow to a company that for publicity reasons wants an estimate lowered? Yep, you guessed it, Fool -- conflicted motives between the firm the analyst works for and the company the analyst covers. If the company's initial public offering was underwritten by the firm the analyst works for, for example, the analyst may be encouraged to do what he can to keep the company happy. After all, in that situation, the company is a client of the analyst's firm, and customer service is king there as it is anywhere.
If the analyst works for a money manager as opposed to an investment bank, it still may behoove him to keep the company happy. Perhaps the firm owns shares of the company he's covering. Maybe they have a lengthy relationship with the company. Keeping doors of communication open between the analyst and the company is important to both. It's a balancing act, in many ways, with one side not wanting to demand too much from the other.
From this miasma of earnings estimates, there has emerged a little thing called a "whisper number." A whisper number is basically an unofficial earnings estimate that's floated on Wall Street towards the end of a company's quarter. Its value depends on whom you're talking to. Some give it zero credence, but others look at it as the estimate number the analysts would like to put out there, but that the company in question doesn't support.
One former analyst I talked to told me that whisper numbers are driven in part by analysts' laziness. Coming out as they do towards the end of the quarter (by this time, you must understand, the analyst is already looking far ahead at the quarters to come), instead of bothering to change his assumptions and model formally, he'll just create a whisper number instead. It's easier than having to go back through the entire process of coming up with an official published estimate. Whisper numbers have proliferated as published estimates have more frequently become the result of a game between the analyst and the company in question.
Should Fools pay attention to whisper numbers? Indeed, should we pay attention to published estimates? Take them, as you would an analyst's "buy" recommendation, with a grain of salt, as they may be more influenced by the firm's relationship with the company than by anything else. Truly Foolish investors will be long-term owners and won't get hung up on whether or not their companies beat or meet estimates. With the knowledge that a company shattering Street expectations may not actually be a big shocker to anyone, taking a long-term view should prove easier. In short, a company beating estimates may not, in fact, be a meaningful thing.
I don't want to paint with too broad a brush, as there are circumstances and situations where an analyst changing an estimate is not an underhanded, sneaky thing, where a company sincerely believes that the analyst has the wrong assumptions in place and the analyst trusts the company. However, be aware of the conflicts of interest that can exist on Wall Street. Usually, beating estimates just isn't all it's cracked up to be.
Do you pay attention to earnings estimates? Why or why not? Talk about it on the Eyes on the Wise Discussion Board.
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