Earnings expectations: Why most big companies beat the Street's predictions

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earnings-expectations-why-most-big-companies-beat-the-streetsWith earnings season under way, I was surprised to learn from an AP article that 81 percent of companies that have reported so far this quarter have exceeded Wall Street's earnings expectations. Are these companies doing so spectacularly well in their businesses despite the worst recession in 70 years? Absolutely! As long as you think that their business is influencing Wall Street's earnings expectations.

By that measure, public companies have been remarkably successful. The AP reports that 81 percent of the first 199 S&P 500 index companies to report earnings came in above expectations on their third-quarter 2009 results. But it's not just this quarter -- over the past two years, 65 percent of earnings reports have beaten estimates. And after last fall's financial crisis, companies beat expectations at about twice the rate as they missed in the following two quarters.

Why is this happening? It's simple, really.

The Wall Street analysts whose earnings forecasts get averaged to specify quarterly earnings expectations are not paid directly for their work. Their forecasts are subsidized by their employers' investment banking and trading businesses. Did you think that those analysts were looking out for the interests of the general investing public?

If so, I am sorry to disappoint you. Their real bosses are the folks who run their institutions' investment banking and trading units. And in order for those analysts to keep their bosses happy, the analysts must avoid making the banks' corporate clients angry.

The best way for an analyst to stay on a client's good side is to agree with whatever quarterly earnings number management wants them to promote. If analysts at banks did their own independent research and came up with more realistic estimates, it could cost their corporate clients some serious money.

How so? As I posted in 2006, stock prices change based on companies' performance relative to expectations. If a company beats expectations and raises guidance, the company's stock pops. Otherwise, it falls. If an analyst raises expectations so high that the company misses them, then its stock price falls.

And then that company's executives will suffer a painful drop in their net worth -- assuming they are big owners of the stock. Their response to that will be to go to the bank's heads of investment banking and trading, and tell them that they will avenge themselves for that loss of worth by switching the company's business to a competitor, one whose analyst promoted earnings numbers that the company could beat.

And then the punished bank will replace its aberrant analyst with one who toes the corporate line.

Any questions?

Peter Cohan is a management consultant, Babson professor and author of nine books, includingCapital Rising (due in June 2010). Follow him on Twitter.

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