Like young Pip's aspirations in the Charles Dickens novel Great Expectations, Wall Street expects great things from companies. It's not enough to have done great things in the past. Companies must continue to do great things -- now and in the future.
For better or worse, Wall Street chooses earnings as its metric. Companies are judged according to their ability to increase earnings from the same period a year earlier (year-over-year), as well as to meet or exceed a consensus of analysts' estimates. But sometimes just meeting estimates isn't good enough, and stellar past performance can even work against companies.
Last week, Home Depot (NYSE:HD) reported its earnings for its fiscal fourth quarter, ended Jan. 30. At $0.47 per diluted share, earnings increased almost 12% from the year-earlier period. However, earnings met but did not exceed analysts' estimates of $0.47. Now, since Home Depot had beaten the Street's estimates in the previous seven quarters, this report was very bad. Wall Street benchmarked the company's earnings against its seven-quarter winning streak, and investors responded by sending share prices down by 4%.
Covering analysts' reaction to Home Depot's earnings announcement, The Wall Street Journal quoted an analyst at Sanford Bernstein as saying, "People expected it to be a little better than expected. That's how it works."
Even if companies beat estimates in the trailing quarter, they are expected to continue to meet, if not beat, analysts' estimates in future quarters, and they're closely watched for changes in management's projections or the dreaded "guidance below expectations."
In mid-January, Motorola (NYSE:MOT) reported a solid quarter and beat estimates, but it issued a softer-than-expected forecast for its March quarter, with earnings estimates in the range of $0.17 to $0.20. But Wall Street had expected $0.20 firm, and shares were down 6% on the news.
So, should you pay attention to Wall Street's great expectations? If you're running a hedge fund with a short investment horizon, maybe. But for most Fools, the answer's a big, fat "No." There are far more important things to analyze when looking at a company and evaluating it as an investment than merely "meeting or beating" earnings expectations. Look past the noise and dig into the company's financials, particularly its cash flow statement and balance sheet.
So while contrarian investors should watch market fluctuations to buy good companies on the cheap, there are pitfalls in being too much of a short-term market watcher -- and advantages to being among the long-term value investors schooled in the philosophy of Buffett and Graham.
For more on why Motorola might be more of a pick for the long haul than the short haul, check out Rich Smith's Stocks Fools Love: Motorola.
Fool contributor Chris Cather owns none of the stocks mentioned and believes in studying Warren Buffett and Benjamin Graham as the foundation for all equity research.
