Today is Listener Question Day!

Brian asks:

Dear Linda: Thank you for podcast #125, which brought me back as I began to drift into investing outer space. I want to know how earnings forecasts are made; what are they based on? Are earnings forecasts the same as earnings predictions? Are they based on past earnings? Because I didn't think we used a company's historical data when looking at current market trends. Thanks, Brian

Thank you for the questions, Brian.

Earnings forecasts are a compilation of information that is obtained by stock analysts at brokerage firms from a company's management and their own estimates.

As you know from my podcast "What makes stocks go up?", earnings are what matters!

Analysts are called "sell-side" analysts because they are "selling" their research to large pension funds, portfolio managers, and other institutional managers. Their job is to estimate what a company's quarterly and annual earnings will be. Since earnings are reported quarterly, 4 times a year the actual numbers are compared to the consensus's numbers. To calculate them the net earnings are divided by the number of shares outstanding, for an estimate per share. For example, $1.20 earnings per share or EPS might be $12 million/10 million shares). Coverage is initiated with either a "buy" or "hold", rarely is the term "sell" used because often the investment banking side of the firm may have a relationship with the company and wants to support the stock price rather than encouraging selling it.

The consensus is made up of an average of all the analysts estimates. For large cap stocks that can be over 100 analysts and for a small company it may be only a few. Once the consensus number is calculated, sometimes there is a "whisper" number that emerges which is a rumor of a different number (often higher) than the consensus. If a company is growing quickly, a whisper number used to get thrown around indicating the company is doing better than was forecasted and as a result it may boost the stock more. Fair disclosure laws (known as Regulation Fair Disclosure or Reg FD) made this illegal and companies now have to give all investors access to this information at the same time.

A publicly traded company has rules about when they can release information to the public, so analysts fill the void and try to calculate what the earnings will be. They can meet with management and talk about sales projections, stores opening and closing, overseas trends, etc. and the analyst then puts the pieces together to come up with an estimate of what he or she thinks earnings will be for the quarter and the year.

It's a big deal when a company misses estimates by having slower growth or lower earnings than were expected. This happened to Apple recently and they lost $47 billion in market capitalization in one day. That's because money managers manage their portfolios by following what stocks have increasing earnings and a stock becomes a real darling if it is increasing earnings at an increasing rate (but you already knew that because you've been listening to me). You can listen to the podcast on Apple in podcast #125.

When a company misses the consensus earnings estimate, even by a penny per share, it's a big deal. A stock can drop like a rock in that case because the thought is that the company's growth is slowing, which means it might be time to redeploy the money invested in it into a company that is growing faster.

To answer your questions, yes, historical data is considered when analysts are trying to predict the future. They will take into account what I mentioned earlier and try to get as close as possible to the actual numbers.

When actual earnings reported beat the forecasted earnings, usually the stock rises because it has "exceeded expectations". If it meets consensus earnings, it often will sell off a bit because it only "met expectations", especially if the stock price has risen going into earnings season. That's an old Wall Street expression known as "buy on the rumor and sell on the news", which is what often happens during earnings season.

One bad quarter can impact a stock's price negatively for fear that it's a trend of future slower growth. However, if there's a good explanation such as a colder winter with more snow caused shoppers to be snowed in and stay home thereby temporarily depressing sales, there's some leeway allowed. But if there's a trend of slower sales that persists and turns into lower earnings, it will eventually be reflected in a lower stock price.

The best thing to do is keep finding those companies that have earnings rising at a rising rate. That company will continue to exceed expectations until they don't. Hopefully by then they are the size of Apple's market cap and one of the largest companies in the world.

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145: How are Stock Earnings Forecasts Made? 11:54 Share

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145: How are Stock Earnings Forecasts Made?