Learn to Play the Earnings Game

Topics: Stock market, Finance, Financial statements Pages: 9 (3627 words) Published: August 24, 2013
Learn to Play the Earnings Game (and Wall Street Will Love You) The pressure to report smooth, ever higher earnings has never been fiercer. You don't want to miss the consensus estimate by a penny--and you don't have to. By Justin Fox

In January, for the 41st time in the 42 quarters since it went public, Microsoft reported earnings that met or beat Wall Street estimates The 36 brokerage analysts who make the estimates were, as a group, quite happy about this - the 57 cents per share announced by the software giant was above their consensus of 51 cents, but not so far above as to make them look stupid. Investors were happy too, bidding the already high-priced shares of the company up 4% the first trading day after the announcement. In short, for yet another quarter, Microsoft had kept its comfortable spot in the innermost sphere of corporate paradise. This is what chief executives and chief financial officers dream of: quarter after - quarter after blessed quarter of not disappointing Wall Street. Sure, they dream about other things too-- mega-mergers, blockbuster new products, global domination. But the simplest, most visible, most merciless measure of corporate success in the 1990s has become this one: did you make your earnings last quarter? This is new. Executives of public companies have always strived to live up to investors' expectations, and keeping earnings rising smoothly and predictably has long been seen as the surest way to do that. But it's only in the past decade, with the rise to prominence of the consensus earnings estimates compiled first in the early 1970s by I/B/E/S (it stands for Institutional Brokers Estimate System) and now also by competitors Zacks, First Call and Nelson's, that those expectations have become so explicit. Possibly as a result, companies are doing a better job of hitting their targets: for an unprecedented 16 consecutive quarters, more S&P 500 companies have beat the consensus earnings estimates than missed them. Microsoft's prodigious record of beating expectations is due in large part to the company's prodigious growth, from annual revenues of $198 million at the time of its IPO in 1986 to more than $9 billion now. It also helps that it dominates its industry. But even the Microsofts of the business world have a few tricks up their sleeve. The most obvious is to manage earnings. "Managing earnings" has a pejorative, slightly sleazy ring to it, but even at the most respected of companies accounting and business decisions are regularly made with smoothing or temporarily boosting earnings in mind. Not all are as up front about it as General Electric, where executives say openly that they don't think their company would be as popular with investors if its profits weren't so consistent and predictable. But neither can it be a complete coincidence that of the top ten companies on Fortune's 1997 Most Admired list, seven--Coca-Cola, Merck, Microsoft, Johnson & Johnson, Intel, Pfizer, and Procter and Gamble--have missed fewer than five quarters in the past five years, according to I/B/E/S (and two of the other three don't have any earnings estimates to meet. Meeting the estimates is made easier by the fact that they're not set in a vacuum-analysts rely heavily on guidance from companies to form their forecasts, and companies have in recent years figured out that it pays to guide the analysts to a lower rather than a higher number. At least partly as a result of this expectational interplay, the price of missing a quarter has risen sharply, particularly among high priced growth stocks. In the growth stock fraternity, "missing by a penny" now implies the height of corporate boneheadedness - that is, if you couldn't find that extra penny to keep Wall Street happy, then your company must really be in trouble, and since missing by a 1

penny is already going to send your stock plummeting, you're better off missing by a dime or two and saving those earnings for the next quarter. Microsoft...
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