Why Analyst Estimates Are Overrated
David Kretzmann | Jun 05, 2018 10:48
Earnings season is often a busy time for investors like us at The Motley Fool. Every quarter management teams update investors on how their respective companies are performing, often give or update guidance for next quarter and/or the remainder of the year, and the stock market reacts accordingly.
Volatility in earnings season is common, as investor sentiments change and people endlessly speculate about where any given company is headed in future months.
When you take a step back from the earnings madness, however, it begins to look a bit silly. Does it really make sense for companies to focus on – and be judged by –- how they perform over arbitrary 90-day periods?
Of course, it’s never fun seeing one of your stocks get whacked after reporting earnings the market didn’t like. Despite the volatility earnings season brings , history shows that the earnings hoopla is almost entirely irrelevant for patient investors.
To understand why, take an example from 2016.
Were tech companies doomed in 2016?
Almost two years ago to the day, I was interviewed by a tech reporter, who was asking what can be deduced from disappointing "tech earnings" so far in that particular earnings season. Microsoft (NASDAQ:MSFT), Twitter, Alphabet (NASDAQ:GOOGL) and Apple (NASDAQ:AAPL) had all missed estimates for the quarter. The horror! Run for the hills!
Well, they sort of missed estimates. They missed analyst estimates. Just look at some of these headlines:
Rotten Apple: Stock plunges 8% on earnings, revenue miss (from CNBC)
Twitter can't stop disappointing investors (from Yahoo (NASDAQ:AABA) Finance)
Microsoft Reports Weak First Quarter Results as Cloud Computing Growth Slows (from Inc.)
Alphabet falls after results miss on top and bottom (from CNBC)
These are some scary headlines. Based on the headlines one might have deduced that dark times were ahead, save for one key fact: These companies didn't miss their own estimates. Somehow overlooked is that each of the companies met the guidance they had provided just three months earlier (except for Alphabet, which doesn't provide financial guidance).
Apple had projected revenue for the quarter to come in between $50 billion and $53 billion. Sales came in at $50.6 billion.
Twitter guided for revenue growth in the range of 36% to 40% for the quarter. Revenue grew 36%.
It was a similar story for Microsoft and the company's three operating segments. Alphabet doesn't provide quarterly guidance, but it grew sales 17% and net income by 20%. Free cash flow grew 43% to $5.2 billion. I went out on a limb at the time and surmised that the company was going to be OK.
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Looking back two years after the fact, it almost seems absurd to see how much time people spent worrying about how these four companies had missed analyst quarterly estimates. In fact, all four companies have trounced the S&P 500 over the past two years:
In short, speculation over quarterly results get increasingly absurd (and misplaced) the longer your investing time horizon. The short-term worries, speculation and volatility become little more than noise to the patient investor.
When earnings guidance matters
Financial analysts, the media and investors at large are nothing short of obsessed with analyst estimates during earnings season. If a company misses analyst estimates, surely the results are no good. Move on and find a company that beat estimates.
I take another view, paying little attention to whether a company is missing, meeting or beating the quarterly estimates of analysts. Instead, my main concern is whether a company is meeting or exceeding its own internal guidance.
No one knows a company better than its own leadership. Therefore, I pay closest attention to the guidance provided by management, not analysts. I'd actually prefer more companies join the ranks of Alphabet and Berkshire Hathaway (NYSE:BRKa) and not provide financial guidance, and just focus their energy on running businesses for optimal long-term performance. The business performance will speak for itself.
Remember, it is not a company's job to meet or beat analyst estimates, even if earnings season headlines sometimes might have us believe otherwise. We want to invest in management teams that take actions to generate sustainable long-term growth and reward stakeholders over the long haul, rather than potentially jeopardizing the long-term health of a business by juicing short-term numbers solely to hit analyst estimates.
Why analyst estimates are overrated
Of course, analyst estimates can (and often do) influence the movement of stocks in the short term. The stock market is forward-looking, and analyst estimates play a role in measuring expectations for a company (thus influencing the share price). No doubt it hurts when stocks we own are hit largely due to missing analyst estimates.
When you lengthen your time horizon, however, the impact short-term analyst estimates have on a stock's performance is considerably reduced. If your investing time horizon is at three years or longer – like us at The Motley Fool – the performance of the underlying business fundamentals matters far more than whether or not a company is meeting analyst estimates.
Just look at what McKinsey, a global consulting firm, found in its research on analyst estimates:
In the near term, falling short of consensus-earnings estimates is seldom catastrophic. Even consistently beating or meeting consensus estimates over several years does not matter, once differences in companies' growth and operating performance are taken into account. In fact, a company's performance relative to consensus-earnings estimates seems to matter only when it consistently misses them over several years.
A lousy company that consistently beats estimates over the short term is unlikely to outperform a quality business that performs well over the long term and occasionally misses analyst estimates along the way. Business performance is what drives the long-term performance of a stock, not analyst estimates.
McKinsey even cautions executives on letting analyst estimates influence business decisions (emphasis added):
Executives commonly believe that missing consensus-earnings forecasts will penalize their share price. We have found that is not the case, and executives should not take extreme measures to meet or beat estimates. Doing so may damage business health over the longer term. Rather, leaders should keep their focus on creating value, since that is the only reliable way to create durable shareholder returns.
There is an important lesson here for us as investors, too. Focus on finding companies that are creating value and have a good chance to continue creating value for many years. Those are the companies that will drive long-term returns for your portfolio .
The Foolish bottom line
Keep these lessons in mind in future earnings seasons. Rather than worrying about whether or not companies are meeting analyst estimates, these are the types of questions investors should be asking:
- Is the company creating value?
- Is the company taking steps to expand its competitive advantage?
- Is the company meeting its own guidance and goals?
- Is this a company I'm confident holding for the next three to five years or more?
- Is management more focused on generating long-term value or juicing short-term results?
These are precisely the types of questions we ask when we’re recommending a company in our flagship investment recommendation service, Stock Advisor Canada.
Simply put, we focus on what really matters – the underlying performance of the businesses we recommend – rather than getting swept up in needless speculation about analyst estimates and quarterly expectations.
We’re marching to a different tune in Stock Advisor Canada, and it’s been a profitable one. Our collection of stock recommendations has nearly doubled the market since the service began in October 2013. And we continue to believe similar results are out there for the next five, 10, 20 years for patient investors.
David Kretzmann
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