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The Market's Reality Show

A Guide to Earnings Season

William Hester, CFA
January 2004
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Reality makes a habit of confronting the expectations of markets. Fed meetings, employment data, and corporate takeovers are some of the endgames of these forecasts. But no time of the year hosts as many collisions between what's expected and what actually is then earnings season. And there will be no busier time this quarter for profit proclamations then the next two weeks.

Scheduled to announce earnings are software companies Microsoft and Siebel Systems, drug maker Pfizer, and banks like Mellon Financial and Wells Fargo. More than 50 of Standard & Poor's 62 industry groups will be represented and by the end of the period more than half of the companies in the S&P 500 will have reported their results.

The results will be watched closely because this earnings season carries a special burden. Operating earnings fell by 30 percent in 2002 and then surged 40 percent last year. With so much volatility in profits, analysts can't be sure of the underlying trend.

Their best guess is that companies in the S&P 500 increased profits last quarter by 22 percent versus the same three-month period a year earlier. This year, they expect earnings to grow 13 percent in each of the first two quarters. For the full year, earnings should be up 12.8 percent compared with the results of 2003.

Investors should hope so, because the level of stock prices leaves little room for error. The S&P 500 is trading at 22 times 2003 earnings, if fourth quarter profits come in as expected. That compares to a long-term average of 15.

High expectations mixed with a difficult forecasting environment will make for an interesting few weeks. So how do you monitor this flood of information that's about to hit? Here's a guide to the benchmarks to watch and a glossary of the terms you'll likely hear.

The First Wave - How Is It Going?

Each earnings season brings three waves of information from companies. The first is guidance, the second is actual earnings, and the last is an outlook. Each wave of information becomes more important than the last.

About two weeks before the end of each quarter companies begin to announce whether they will meet the expectations of analysts. This 'confession period', as Wall Street calls it, can help set the tone of the season.

The news is always bad. The question is: how bad? On average, companies that guide earnings estimates down outnumber those that raise them three to one, according to Thomson Financial. This so-called guidance ratio has been as high as 7 (during the second quarter of 1998) and as low as 1.5 (at the markets peak).

So far this quarter, the news has been less bad than usual - which is good. The guidance ratio stood at 1.3 last week but more announcements are on their way.

The Second Wave - How'd It Go?

Investors' focus quickly changes from the guidance companies give to their actual results. The pace of earnings announcements looks like a bell curve. Less than ten percent of the companies in the S&P 500 announce in each of the first two weeks of a quarter. Then two-thirds of the companies report results in the span of three weeks. The pace then slows through the end of the quarter. (Not all companies report results through December, though. The majority of retailers, for example, close their books at the end of January.)

In this flurry of results, a lot of attention will be placed on the surprise factor. This measures the extent by which a company beats analyst expectations (which very often have already been lowered numerous times by company guidance). Actual results beat expectations by 3 percent, on average, says Chuck Hill, Thomson's earnings guru.

There's more good news here, too. Through last Friday, the 66 companies in the S&P 500 that had announced fourth quarter results beat expectations by nearly eight percent. That number helps to explain investor enthusiasm so far this year.

The Third Wave - How Will it Go?

Ultimately, stocks look ahead. For this reason, company forecasts trump past successes. Even stocks with strong results can plummet if they deliver tepid outlooks with their results.

The overall trend in the earnings outlooks can be measured by analyst forecasts for the current quarter. Both Standard & Poor's and Thomson Financial track these forecasts and create an aggregate 'bottoms up' number. This figure will rise and fall with new outlooks from companies.

Strategists and economists also generate aggregate forecasts for profit growth. They derive their earnings projections based on forecasts of economic growth. These 'top-down forecasts' are usually less optimistic than analysts. This year, while analysts expect earnings to climb 12.8 percent, strategists and economists see 10 percent growth.

Because of the upbeat guidance period and healthy profit surprises so far this quarter, investors have awarded companies with higher stock prices. But even if companies continue to beat investor expectations this quarter, they aren't out of the woods. It will become more difficult for them to impress investors later in the year. Quarterly earnings are compared with the same three-month period a year earlier. Since earnings collapsed in 2002, impressive gains were easy to achieve last year. As 2004 continues, last year's good news will set a considerably higher bar to clear.

Pick Your Measure. A Glossary to the Earnings Reporting Season

The First Wave:

Guidance/Confessions/Pre-Announcements: These terms refer to announcements made by companies prior to the official release of their financial results. Companies either confirm or adjust investor expectations. The duration of these announcements span about a month and begin in the last two weeks of each quarter.

The Guidance Ratio: This is the number of companies that provide negative guidance relative to those who deliver positive news. The ratio has ranged from 1.5 to over 7. A higher ratio sets a negative tone for the upcoming earnings season.

The Second Wave:

Reported Earnings: This is a measure of income after all expenses except for the impact of accounting changes, discontinued operations, and extraordinary items. This number follows Generally Accepted Accounting Principles (GAAP).

Operating Earnings: This term can have different definitions. Standard & Poor's and Thomson Financial calculate it as earnings that don't include one-time events, like when a company sells a physical asset or writes off an investment. However, there's no agreement about what adjustments should be made because operating earnings are not accepted under GAAP.

Companies present this number because it typically boosts their earnings figure. In the late 90's, the operating earnings of the S&P 500 companies averaged more than 20 percent higher than reported earnings, according to a 2001 study done by the Levy Institute 1 . In any one quarter the difference can be even more dramatic. An August 2001 Wall Street Journal study found that for every dollar of operating earnings the S&P 500 companies reported in their most recent three-month period, 60 cents wouldn't have been there if ordinary business expenses under GAAP hadn't been excluded 2 .

To make matters worse, there is more than one aggregate operating earnings figure. Both S&P and Thomson collect estimates for operating earnings, but their final numbers differ. The operating earnings figure calculated by S&P tends to be more conservative, and therefore lower, than Thomson's.

Earnings Surprise: A measure of how actual results compared with expectations. Historically, the average company in the S&P 500 index has announced earnings three percent higher than what was expected.

Pro-forma Earnings: This was a legitimate term until it went bad. Pro-forma earnings had been used in the case of a merger to represent the financial statements of the combined company. Then the tech bubble hit. Many start-ups began using a pro-forma figure to describe earnings before important business expenses, like advertising or the amortization of goodwill. If you see this figure used, laugh mildly, and move on. Then if you can, recalculate the profit with the appropriate expenses.

Core Earnings: Introduced in 2001 by Standard & Poor's, core earnings attempt to standardize operating earnings. Expenses such as the cost of providing a pension plan, purchased research and development, and employee stock option grants - all obvious ongoing business expenses - are deducted when calculating profits. Items excluded from core earnings include gains in pension assets, merger and acquisition costs, and asset sales. Though conceptually sound, the core earnings calculation hasn't gained any traction since its introduction. It probably won't. The operating earnings food chain is difficult to alter at this point. Companies want to publish profits that make their stocks look like good values; analysts want to stay friendly with the companies they cover to ensure access and future investment banking work; data companies have only analysts to turn to for earnings estimates; and the media needs to compare earnings results to expectations, so they turn to data companies. Without SEC intervention, it's a juggernaut.

EBIT: earnings before the deduction of interest and taxes.

EBITDA: moving further up the income statement, EBITDA is earnings before the deduction of interest, taxes, depreciation, and amortization. This is sometimes referred to as operating cash flow, but there are differences.

Operating Cash Flow: net income + depreciation - changes in working capital

NIPA Corporate Profits: This data is released by the government as part of the National Income and Product Accounts and is based on the tax receipts of all US corporations. Since corporations pay taxes based on this number, there isn't any reason to inflate it. Economists and strategists use this number as a reality check for the operating profits released by the companies in the S&P 500.

Wave Three:

Bottom Up Estimate: The aggregate expected earnings per share number based on the forecasts of security analysts. The estimates are often wrong, so they should be interpreted with caution. Generally, analysts underestimate earnings when they're rising, and overestimate them during recessions.

Top Down Estimate: The aggregate expected earnings per share number based on the models of economists and strategists. This number tends to be less optimistic than that of bottom up estimates.

1 Walter Cadette, David Levy, and Srinivas Thiruvadanthai, Two Decades of Overstated Corporate Earnings: The Surprisingly Large Exaggeration of Aggregate Profits , The Levy Institute Forecasting Center, September 2001.

2 Jonathan Weil, Companies Pollute Earnings Reports, Leaving P/E Ratios Hard to Calculate, Wall Street Journal, August 21, 2001.


The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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