How Companies Manage Earnings Expectations


LONDON -- A common theme of some financial stories is that company X's latest earnings report has beaten the market forecast, so its shares have risen accordingly. What often happens is that the company had been guiding the market to its profit expectations, but this guidance targeted a figure that was a bit less than what it really expected to make.

The idea is that when the company then beats the analysts' estimates, the market will be impressed, its share price will jump, and the shareholders will be happy. This practice is something to be aware of, especially as a few companies will go to great lengths to manipulate their reported earnings.

How to beat the estimates
Along with the increasingly common habit of reporting several different earnings per share and then highlighting the best one, some companies deliberately manipulate their profits by taking full advantage of the accounting rules. One of the easiest ways to do this is by selling stuff to realize a capital gain just before the accounting date, solely in order to provide a one-off boost to profits.

A few companies will do very dubious things, such as booking the profit from contracts that won't even be started, let alone finished, in the current quarter, or shoving losses through the balance sheet, rather than the profit and loss account. Investors need to be aware that if a company is consistently beating the market's expectations, then something fishy might be going on.

Back in the 2000s, the expert at "earnings management" was the conglomerate General Electric (NYS: GE) , as it always beat the market's expectations. This was in large part done by "aggressive" accounting techniques, such as booking profits on sales that turned out to be loans and using exotic derivatives.

Eventually General Electric was caught, and the company ended up paying a fine of $50 million to the Securities and Exchange Commission in 2009 in return for the dismissal of all ongoing investigations.

Any figure you want
One company that doesn't manipulate its earnings is Warren Buffett's Berkshire Hathaway (NYS: BRK.B) . Berkshire goes so far as to deliberately draw attention to its big mistakes by highlighting things that many other companies would have hidden in the notes to the accounts.

A good example is the recent massive writedown of its holding of what was $2 billion in bonds issued by the private utility company Energy Futures Holdings. This loss was given a section of its own on page four of the 2011 annual letter in order to draw it to Berkshire shareholders' attention.

Buffett is on record in the 2010 annual report as saying that net income was "almost always meaningless at Berkshire" because the company could legally change this to pretty much any figure it wanted. The reason is that Berkshire can always sell some of its investments to realize gains (or losses), which would then be added to its net income for the current year.

For example, if Berkshire had sold its shareholding in The Coca-Cola Company (NYS: KO) in 2010, this would have realized almost $12 billion worth of capital gains. After deducting capital gains tax, Berkshire's reported net income would have almost doubled.

Buy on the rumor...
Another thing to be aware of is that a share price always includes some account of the stock market's expectation as to the company's future earnings. New investors are often surprised when good news is published, only for the company's share price to fall sharply. This happens because the good news was already in the price, and the market was hoping for even better news.

This leads to the popular saying, "Buy on the rumor, sell on the facts," because the rumor has all too often been priced in at a level that isn't supported by the facts when they become known.

Warren Buffett buys a British blue chip! Read this special report -- "The One UK Share That Warren Buffett Loves" -- while it's still free and available.

Further investment opportunities:

At the time thisarticle was published Tony owns shares in Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway and Coca-Cola.Motley Fool newsletter serviceshave recommended buying shares of Berkshire Hathaway and Coca-Cola. The Motley Fool has adisclosure policy.
We Fools may not all hold the same opinions, but we all believe that
considering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.