Monday, October 26, 2009

Companies' earnings forecast is full of low-balling

CHICAGO — More than 80 percent of major companies reporting third-quarter results this month have beaten Wall Street expectations. So is business that good? No. Are companies gaming the system? Yes.
Corporate America has a habit of low-balling the earnings forecasts used by analysts to determine their estimates. That way, the bar is lower, and companies can easily jump over when the quarter's results are announced — even if profits and revenues have fallen off a cliff.

"Over the last decade, there's been a distinctive tendency for companies to under-promise and over-deliver," said Dirk van Dijk, chief equity strategist of Zacks Investment Research. "Lately companies are being even more cautious. They realize investors can very harshly punish any company that disappoints."

Beating expectations generally gives share prices a quick lift, but the news can mislead investors about the real state of the business — and just how far this economic recovery has to go. In fact, of the companies reporting third-quarter results so far, 60 percent have posted lower net income compared with a year ago.

Still, the recession has accelerated the flow of positive earnings "surprises" as companies play it safe and issue more conservative earnings forecasts. In the past two years, 65 percent of earnings reports have beaten estimates. Even after last fall's financial crisis, the next two quarters had nearly twice as many beats as misses.

This quarter, 81 percent of the first 199 companies listed on the Standard & Poor's 500 index that reported earnings came in above expectations.

The focus on expectations can distract investors from more meaningful numbers. This summer, earnings stories trumpeted how banks beat expectations. Many investors lost sight of the fact that earnings were down considerably for most banks and that troubles still shadow the sector.

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