During earnings seasons you surely compare companies’ reported EPS with analysts’ consensus estimate (or past EPS) and react to consensus misses or beats. But is a 3-4 penny miss really meaningful? Does it indicate a performance deterioration that should worry you? In most cases, the answer is no.
The key to understanding this is to recognize one of accounting’s great secrets: Financial reports used to reflect facts: sales, purchases, or interest payments. No more. These reports are now riddled with hundreds of managerial estimates and even guesses, prone to error and manipulations. Consider: Most balance sheet and income statement items are derived from estimates: Assets are reported net of depreciation and amortization (estimates), accounts receivable is reported net of the bad debt reserve (estimate), the pension expense — a big ticket item for many companies — is based on multiple estimates, including sheer guesses: the “gain on pension assets,” for example, which requires managers to estimate the long-term (5-7 years) future performance of capital markets (good luck predicting tomorrow’s performance). Employee stock option expense is also based on 3-4 individual estimates, and so on, down the line of the income statement. You surely think that sales (revenues) at least are factual. Think again. General Electric’s footnote on Sales of Good and Services includes the following: “We estimate total long-term contract revenue … we recognize sales … in relation to our estimate of total expected costs … we measure sales … applying our contract-specific estimated margin rates …” Estimates everywhere.
Is the proliferation of estimates in financial reports a recent phenomenon? Is that why you didn’t hear about it? Indeed, it is. The attached figure, from our book The End of Accounting…, vividly shows the steep increase in the mean and median number of estimates and related terms (assumptions, forecasts …) mentioned in footnotes of S&P 500 companies: from 30 mentions of estimate-related terms per company in 1995 to a whopping 150 in 2013. A five-fold increase!
Why this increase? Courtesy the FASB. Every substantial FASB accounting and reporting standard issued over the past 20 years — fair value accounting, assets and goodwill write offs, employee stock options expense, etc. — is based on managerial estimates, rather than facts. A self-inflicted wound to the integrity and reliability of financial information.
The problem with estimates and their underlying forecasts is that in the current fast-changing economic environment and frequent technological changes, the error in estimating future conditions (like assets’ future cash flows) is constantly increasing. And estimates are prone to manipulation. Even if an estimate, say the bad debt reserve, turns out to be far off the subsequent actual outcome, managers can always say that at the time they made the estimate, it was based on their best information. Good luck disproving this.
The upshot: A few pennies difference between the earnings consensus and the estimates-riddled reported EPS often doesn’t mean much; it rarely reflects real changes in company performance. A slight change in an assumption underlying a managerial estimate (like from 4.5% to 4.7% expected gains on pensions assets) may turn a consensus miss to a beat.
The lesson to investors: Rather than being obsessed with quarterly consensus misses or beats, consider the real fundamentals: changes in the subscriber base of an Internet, telecom, or media company; shifts in same-store-sales of retailers; organic (net of M&A) sales changes, the remaining patent lives of pharma and biotech companies’ leading drugs, or non-performing loans and “net interest income” for banks. These, among others, are the measures that matter.
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