How Good Are Earnings Really?

One of the strongest issues in the perma-Bull’s arsenal has been the 16 consecutive quarters of double digit year-over-year earnings growth.

My reservations about earnings have been twofold: First, SPX gains have been unusually reliant on energy and materials stocks, accounting for a disproportionate (by some measures, as much as half) of earnings improvements; Given the drop in oil, copper, steel, etc., (at least short term), these companie’s contribution to S&P profitability are likely to feel some impact. (Longer term, I remain bullish on the Oils). 

Secondly, financial engineering of year-over-year earnings continues via share buybacks. About a third — 5 of the 15% E gains — are due to the massive stock buybacks we have seen. According to Merrill Lynches David Rosenberg, this has reduced share count to the point of improving earnings by that third.

Now, there is another earnings issue worth looking at: Expectation-Management:

"Stephen Biggar, director of American equity research at Standard &
Poor’s, questions the reliability of those estimates. In the weeks
before an earnings announcement, Mr. Biggar said, companies often talk
down their prospects so that analysts reduce estimates, making the
actual numbers sound better. He prefers to compare reported earnings
with estimates made before the expectation-management exercise begins.
Using estimates in place on Sept. 18, he concludes that companies are
not doing as well as many people think.

Of 68 S.& P. 500 companies that have reported third-quarter results, 41 failed to meet the September estimates for operating earnings, he said. The median shortfall was 4.3 percent. But 74 percent of companies in the S.& P. 500 that have reported so far exceeded the latest estimates and only 8 percent undershot them, according to Thomson Financial."

In the final month of the quarter, companies do some "fancy footwork" to bring down estimates. They restate earnings from previous quarters, making the present growth seem more robust, according to Mr. Biggar. "There is a penchant by companies to make this year’s number look good but to make last year’s number look bad," he said.

The reality check? Investors need to scrutinize earnings reports carefully: "A lot of these companies that say they’re 11, 13, 14 percent growers are not," he said. "It’s difficult to have confidence in the numbers they’re reporting."

UPDATE October 24, 2006 3:45pm
Here’s a chart of Third Quarter Earnings and Guidance changes via Birinyi Research —




Comparisons That Make Earnings Look Good
NYT, October 22, 2006

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What's been said:

Discussions found on the web:
  1. JGarcia commented on Oct 24

    Well, here’s a look at the other side of this discussion. The market doesn’t always make “sense”:

    “During the last century in the United States, there have been eight occasions where the P/E declined for three consecutive years. In all but two of them, the fourth year had a large P/E expansion that added to a robust bull market.

    The six positive and P/E expansion fourth years were 1908, 1918, 1942, 1949, 1967 and 1995. Each of them was preceded by a three year span of declining P/E. Each period had multiple economic, financial and geo-political consequences of serious magnitude during the three declining years History buffs can fill in the details for each of these time periods. ”

    Here are the complete comments from David Kotok and Cumberland Advisors, who have changed their view of the markets, and are heading towards a fully invested position. I think they’re spot on:

  2. Barry Ritholtz commented on Oct 24

    I’m friendly with David — I’ll ask him for that research and post excerpts.

    We’ve done some interesting work on P/E expansion and contraction; see this: P/E Expansion and Contraction

  3. jmf commented on Oct 24

    i think this from greenberg fits into this topic

    Earnings Spin, a-la Netflix
    Posted: 23 Oct 2006 11:32 PM CDT
    I’ll say this about Netflix (nflx): It’s as good at managing Wall Street as any company I’ve seen. A quarter ago, for example, it said net income would growth at 50% “in 2007 and beyond.” Then, in its third quarter, reported Monday, it performed a great sleight-of-hand by raising estimates for this year and next, but in doing so lowering its annual net income growth rate to around 30%.

    Then, to head any wawyard analysts off at the pass, CEO Reed Hastings masterfully downplayed the slowing growth during the earnings conference call, by saying “purists will note” that next year’s forecast of $55 million to $60 million “is not 50%” above the upwardly revised 2006 guidance of $42 million to $48 million. “Our response,” he continued, “is [that] $55 to $60 million is more than 50% above the $30 to $35 [million] we expected to generate this year. Whichever side you agree with, you can probably agree it’s a nice argument to be able to have, and we’re excited about another year of great subscriber revenue and earnings momentum.” Nice argument to have – yes — but it’s not the growth promised a mere quarter ago!

    But wait, there’s more: Netflix also said it will stop offering net income guidance, preferring instead to focus on earnings per share, which would bring it “more in line with how financial markets track earnings.” Earnings per share, of course, are also easier to jigger to meet or beat expectations.

    Overall, and on the surface, the quarter was a headline-grabber for the way it handily appeared to beat analyst estimates and the company’s own guidance. But in reality, revenue came in pretty much where analysts had expected them to be before the second quarter, when Netflix gave third quarter guidance that was lower-than-expectations. Earnings, meanwhile, were helped by a lower cost of revenues (revenue-sharing expenses, amortizing its DVD library, amortization of intangible assets and and postage and packaging expenses – in other words, everything but its core DVD rental business) and interest income, largely on cash raised in an offering last spring.

    In fact, it appears increasingly that Netflix is relying on everything but its core DVD rental business to make money. That’s evident by the disparity in margins, with the gross margin rising to 38% from 37% a quarter ago while net margin slipped a few notches to the mid-single digits. The latter two are no surprise considering that average revenue per subscriber continued to slide while subscriber acquisition costs continued to rise.

    Digital downloading won’t come a moment too soon. But more about that, the company says, next quarter. Can’t wait. The beat goes on.

  4. JGarcia commented on Oct 24


    I think you made very interesting comments in your prior PE expansion piece. You mention psychology. I couldn’t agree more with that.

    Since we have spent the last six years in a rotating Hell of news stories, and came out of the worst stock market performance in most of our collective minds, who could blame investors for not driving PE’s even steady with the past 13 quarters of earnings growth. Bonds and housing were the new “smart” investment. Well they worked, but now I think we’re seeing the other side of that trade…where equities play catch up to these asset classes and their own earnings growth. This rally has not yet been “endorsed”, imho, it’s just now starting to appear on the radar screen of those who left the market in 2001-2003.

  5. Richard commented on Oct 24

    Barry do you ever have anything positive to say about the market or are you always searching for the angle to inject your bearisheness? I understand your slant and what makes you popular as an ‘alternative’ view to the bulls but your approach is no different than the permabulls you try and dismiss. Get some balance my friend.

  6. Eclectic commented on Oct 24

    The Thompson Financial head honcho said this morning when asked what’s next after this bully rally:

    “Multiple expansion…. soon…. multiple expansion.”

    If that’s true they’ll be breaking out new cases of caviar and party balloons at the party across the river… on the other side of the bridge.

    The aromas from the party will be wafting across the dark deep water and getting sucked up by our S.O.L. nostrils.

  7. vhehn commented on Oct 24

    and yet the market will not stop. whats a bear to do now that you have missed or worse shorted this run?
    the bear side always sounds so inviting but is so hard to make money on.

  8. Caver commented on Oct 24

    I’d been looking for stuff on expansion and compression of multiples. Thanks.

  9. JoshK commented on Oct 24

    If you are a Bloomberg user, you can just do GE for a graph showing earnings / share and earnings / share $. That’s good for indexes, too.

    A bigger question is of the quality of the earnings. Does a company like AMD really earn $1.30/share or so a year? Or does this money need to be plowed back into R&D in order to tread water.

    IMHO, one day this is going to come back to bite as people realize that tech earnings are a bit more ambiguous than the market is assuming.

  10. Barry Ritholtz commented on Oct 24

    Hey Richard,

    If you look at the Sunday linkfest, there are quite a few positive stories.

    Also, I think most people consider rec’d a stock like IBM or Oracle or Lockheed Martin or BP — all done in public forums like CNBC or Bloomberg TV — is a positive thing.

    Balance is not a goal in itself. As Rob Corddry once said: “How does one report the facts in an unbiased way when the facts themselves are biased?”

  11. Detroit Dan commented on Oct 24


    When something smells, it’s best to try and detect where the odor is coming from. The economy is clearing slowing. How do profits increase at double digit rates in a slowing economy?

    I would be disappointed if Barry did not try to fit the earnings reports into his world view, adjusting the big picture view as necessary to accommodate the new information…

  12. wcw commented on Oct 24

    In re: buybacks, do take them out of earnings growth and stick them into your dividend models, where they belong. They are, after all, cash being returned to shareholders. With rates low, dividends plus buybacks are pretty competitive with treasuries these days; cf S&P’s PDF reporting this for Q2, or my chart of their data. As I said in August, it was “easier to be bearish when dividends-plus-buybacks lagged.” Partly, this is what has kept me long despite my worries about production, profits and earnings going forward.

    I had, as I think I posted to your comments before, October index calls, which kept me from losing too much relative return to index beta. I do not have November calls; I expect Friday’s advance GDP to disappoint, which should give me a nice drop to cover a short or two or buy calls, if I choose.

    We’ll see; I am wrong a lot on these things.

  13. JoshK commented on Oct 24

    If I remember basic finance, stock buybacks are considered much more tax effecient, but the same as a dividend. I think in a behavioral class they asked why don’t more companies do this since buybacks are better.

  14. Mark commented on Oct 24

    One needs to read David Levy’s interview at welling@weeden to hear his suspicions about earnings being managed despite Sarbox. His models fall far short of what is being reported.

  15. S commented on Oct 24

    3Q GDP growth will likely have a “1” handle. Yet, after three consecutive years of accelerating earnings, 3Q earnings will somehow manage to grow 15%.

    We are a bunch of highly producitve mofos.

  16. wcw commented on Oct 24

    You do mean 1.5%, I hope. Even almost a full percent below the bloomerg-reported 2.4% consensus, I would probably take the “under”, though I am less confident there than at consensus.

    In re productivity, didn’t you see the employment revisions?

  17. BDG123 commented on Oct 24

    Kotok going fully invested on October 21st. Remember that date. Without checking, I believe we just passed the longest run on the S&P without a 1% intraday correction in half a decade. The prior two times led to the eight month selloff in 2004 as long bond rates exploded and the other time was the May dump.

    I guess Kotok didn’t major in statistics or he’d know that was the most blunderous decision he could have made from a risk management perspective. Let alone posted on his web site for everyone to see. Nothing like going fully invested just in time to see your portfolio take losses. I think soon he’ll need something similar in spelling to his name to stop the bleeding in his portfolio because we will get a correction. The only question is if it will be a whopper. Unlike his statistics of 80 years past which aren’t relevant from a cycles perspective, the current data points are indeed relevant.

    Four trading days ago, a significant data point started falling off of a cliff. The worst I have seen. Of course I wasn’t collecting it six years ago so maybe it’s not that big of a deal. But, that would be a few days before he appeared to go fully invested. May recover or may not. If it doesn’t, expect some pretty red lights on your stock screens soon. I wouldn’t want to be “betting” on the long side right now even if you are bullish.

    Oh, btw, with the PE on the R2K at higher levels than the S&P in 2000, the Naz PE not much lower and ditto for the Transports, what will happen with a multiple expansion? They go to a PE 2X the S&P in 2000? DOH!

  18. jkw commented on Oct 24

    I got my signal last week that the market topped. The market makers weren’t interested in filling my vertical at what should have been a good price for them (it was .05 below the natural price in a .30 spread). That generally means the market isn’t going to move any further in that direction, at least for a week or two.

  19. Mark commented on Oct 24

    Re Kotok: “I think soon he’ll need something similar in spelling to his name to stop the bleeding in his portfolio because we will get a correction. ”

    Whoa! B is back and in full metal jacket mode! LOL.

  20. joe commented on Oct 24

    Can someone tell me how these markets dont selloff, another record high today. Its getting out of hand. At least when the markets were selling off we would get some bounces, this just doesnt make any sense. Day after day the markets rise. I dont even remember the last time these markets dropped 50 points. I think the next triple digit drop will be a wake up call for many bulls.

  21. Ricardo commented on Oct 24

    Unbelievable that we still have to debate/talk about how companies manouver around their earnings. 5+5 will always equal 10, except when it comes to the twisted minds on Wall Street. Get a grip you bunch of fudgers and maybe once in your pathetic (but highly paid) lives you will report the TRUTH. Analysts are useless turds who lack a backbone, along with the masses who invest based on their opinions and are pricing stocks to perfection when it’s clear that we are long way from it! Earnings ‘adjustments’ are exactly the reason why need to see some generational lows on P/E’s … low 5’s anyone???

  22. mentalmodel commented on Oct 24

    While this is at least a month old, I haven’t seen this source touted much by bears.

  23. Caver commented on Oct 25

    The whole Kotok thing has me baffled. I’d love to know what data he is using. He thanks Shiller at the end of his blurb, but he doesn’t seem to be using Shiller’s P/E data. Even S&P’s own data seems to suggest that P/Es have already declined more than 3 years in a row starting in 2001. Crestmont’s stock matrix (which uses Shiller’s data) seems to show the pattern he is talking about, but the years involved are not all the same.

    Weird. It reminds me of back in 2000 with all of the “Jesus is coming” stuff but no one could agree exactly when 2000 years had passed because of year 0 and the monks adding and subtracting years when they wanted. Kotok certainly left himself many outs. The whole article is not as over the top as the excerpt above. And he was kind enough to link to John Mauldin for a counterpoint. Like I said, weird.

  24. Mark commented on Oct 25

    Yes, P/E multiples have been slowly crushed to present levels. Ya know, they do just that in Secular Bear Markets. Why this seems to be a big point NOW with Mr. Kotok is somewhat puzzling to me. Frankly, I think these managers are reaching for returns and abandoning their disciplines. Even John Hussman has said he will buy calls IF the market corrects to where he feels comfortable doing so. Redemptions from funds playing a role? I think so.

  25. BDG123 commented on Oct 25

    IMO you hit the nail on the head Mark. Kotok is not a dimwit. But I think his recent move was suspect. At least he should have waited to see what a correction will bring.

    He’s chasing and easing his discipline. I really think the pressure from clients to be fully invested when the market is rocketing upwards is rather intense.

  26. ArizonaChartist commented on Oct 25


    “About a third — 5 of the 15% E gains — are due to the massive stock buybacks we have seen.”

    Let’s not forget that stock prices are a function of supply and demand. Given that supply is decreasing, it should not be surprising that price is increasing given a relatively stable level of demand. Therefore, I would have to put this portion of your argument in the “What do you expect?” or “So what?” dust bin.

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