Taking Stock: Beat, Meet or Miss

There are a few things I think everyone should know: that the secret to a good omelet is a non-stick pan, that masking tape is great for hemming pants or skirts in a pinch, and that the way the market reacts to a company's earnings is not based on what you or I think are good results.

I add the last to the list because after years as a financial reporter, one of the most common questions I was asked was: Why does a stock fall when the company reports an amazing gain in sales and profit?

I get why people may not know the answer. I didn't understand how it worked until I started reporting company earnings and someone explained it to me. So let me share what I know for anyone not steeped in the machinations of Wall Street:

The stock of a publicly traded U.S. company may fall even though that company reports an amazing gain in sales and profit because that amazing gain may not be so amazing to the people who get to define amazing.

Who are those people? They're the financial analysts at firms like UBS, Morgan Stanley, Sanford C. Bernstein and Goldman Sachs, among others. These analysts issue reports about the companies they follow, detailing how the company is doing, what challenges and opportunities lie ahead, and how it compares with the competition.

They also devote a lot of ink to their estimates -- that is, their predictions on how much the company should earn (or lose) each quarter. Tweaks to the estimates are made whenever there's news that will affect the top line (sales) and/or bottom line (profit).  

Their estimates are then tallied to get analysts' average estimates for sales and profit for a company every quarter. Those tallies are the numbers stock watchers -- reporters, investors, traders -- look for when companies report their results. And those are the numbers a company will beat, meet or miss.

Still with me?

Let me put it another way: Company A reports a 50 percent gain in sales and a 10 percent rise in profit. Sound amazing? To many people it does, who then expect the market to react positively and the stock to go up. But remember what I said about who gets to define amazing. If the analysts anticipated a 60 percent gain in sales and 15 percent rise in profit, then the company "missed" Wall Street expectations. Even if the company makes one number and misses the other, the miss will be called out and the shares will likely drop.

(I say "will likely" because there are always exceptions. Sometimes a company makes an announcement that gives investors optimism despite a miss -- maybe their sales were better in one area than anyone expected or they're going to acquire another company that will lead to more profit.)

Let me throw one other thing at you, lest you think a beat on sales and profit qualifies as amazing.

There's one other area analysts handicap in an earnings report: the forecast. The forecast is the company's expectation for sales and profit in the next quarter. Not every company gives a forecast, but many do. And analysts estimate what that forecast will be. So a company can also beat, meet or miss on its forecast. More times than not, it’s the forecast that sends share prices up or down. That means even if a company has amazing sales and profit as defined by the analysts, their shares can still fall if they don't also have an amazing forecast.  

The lesson to take from this: Investing in stocks is part science, part art. You can never be sure that the amazing numbers are amazing enough. Hope that's useful. If not, I wish you better luck with your omelets and sagging hems. —CG