Let me qualify that statement a bit. I love when great companies miss earnings estimates due to temporary or non-secular issues because the market generally over-reacts and provides me the opportunity to buy a great company at a great price.

The entire earnings estimate game can be a mystery to some but for those that truly understand it and the absurdity of it, there is an opportunity to make money with minimal risk. Let me explain the process and why it is absurd.

Most public companies report financial performance (earnings) at the end of every quarter and typically the two most followed metrics are Earnings Per Share (EPS) and Revenue. At investment banks, there are equity research analysts that work diligently to follow (referred to as "covering") these companies and their financial performance. They periodically publish reports about these companies that forecast things like revenue, margins and EPS. These analysts also publish ratings on the stocks of these companies that typically fall into three camps: Buy, Hold or Sell. Typically, there are several equity research analysts from different investment banks that "cover" a large company. For example, a large company like Google is covered by over 40 equity research analysts (see list of equity research analysts that cover Google here).

All of these research analysts publish their predictions for EPS sometime before the company announces its earnings. Many of these research analysts forecast EPS estimates that are within a tight range of one another. Occasionally, there are also some estimates that are outliers to the upside or the downside. Then, a third party company like Thomson Reuters (formerly known as First Call) aggregates all of these EPS estimates from all of these different analysts and calculates an average. This average is called the consensus estimate and the industry standard is called the First Call Consensus or Thomson Consensus (First Call is now owned by Thomson Reuters).

When you see news headlines that a company missed or beat earnings, financial journalists are typically referring to the company's reported EPS relative to the First Call Consensus estimate. When companies beat the consensus estimate, the market will often overreact and the stock price will rise significantly, even if the earnings beat is only by a few cents. And when companies miss the consensus estimate, the market will often overreact the other way thereby decimating the stock price, even if the miss is only by a few cents. I have some big issues with all of this:

We take an average of a bunch of different equity research analysts and hold this out as the "official" consensus number. These analysts are clearly of differing quality and experience, but we assume that the average of them will more or less provide an accurate prediction of the future. Merely averaging numbers does not provide a more accurate number if all the input numbers suffer from inaccuracy.
The idea that someone can predict the earnings of a company within a cent or two borders on lunacy. There are a million different drivers (several revenue drivers, several expense buckets, shares outstanding, etc.) that drive that Earnings Per Share number and it is nearly impossible that an external analyst could accurately forecast all of these drivers to compute an EPS number down to the cent for a given quarter. Even someone working at said company with full visibility to all the revenue and expense inputs on a daily basis likely could not predict the EPS down to a cent with full accuracy.
The importance that is afforded to missing or beating the quarterly earnings consensus by Wall Street is far too much and takes the focus off of the more important story- the big picture and the long term. A company may miss or beat an arbitrary earnings consensus number from time to time driven by temporary factors, but what is more important and should drive the stock price are factors like:
- Is the company allocating capital efficiently?
- Is the company driving higher willingness to pay for its products and improving margins?
- Is the company building a sound business with a durable competitive advantage?
The importance afforded to quarterly earnings also drives some management teams astray and encourages bad behavior. CEOs and CFOs become obsessed with trying to make sure they meet or beat a quarterly earnings number (lest their stock price get decimated) rather than operating their business for the long term. This short term thinking can lead to poor decision making and even questionable behavior. It isn't completely their fault because they are often criticized and booted by the Board if they fail to meet certain objectives for a given quarter.

So what does this all mean. It means that the astute value investor shouldn't place much importance on whether or not a company meets, beats or misses quarterly earnings estimates. Rather, the astute investor needs to look beyond the simple beat or miss and focus his energy on evaluating the company's performance against some of the criteria I established above. Doing this will enable him to profit at the general market's folly (also the name of a great investing blog - marketfolly.com). In other words, great companies will often miss earnings for inconsequential reasons and the resulting overreaction by the market will drive the stock price down. This provides an opportunity for the astute investor to pick up shares at a favorable price.

This happened with Disney (DIS) some time ago (August 2011) and provided me with an ideal opportunity to buy in to this wonderful company at a very favorable price. In this case, Disney actually beat earnings estimates (78 cents per share vs. a consensus estimate of 73 cents per share), but the analyst viewpoint was that Disney didn't beat in the "right" way and had certain revenue not been counted, the company would have missed estimates. Also, the analyst community thought that expenses in the quarter were way too high (article here) as a result of new broadcast contracts with sports leagues and higher marketing costs for the Pirates of the Caribbean movie. As a result, the stock dropped more than 9% to ~$30.

What I saw was a wonderful company with amazing franchises (Toy Story, Marvel super heroes, Disney theme parks, Mickey Mouse, ESPN) that has historically been able to drive higher willingness to pay from its consumers because its offerings are high quality and very unique. Furthermore, Disney was run by a management team that had historically made very smart acquisitions like Pixar and Marvel that were within its circle of competence. Finally, after the selloff, Disney was trading at a historically attractive valuation. Despite a ratings cut to Hold or Sell by several analysts, I pounced on the opportunity. Since then, Disney has returned an annualized return close to ~40% (not including dividends) versus the S&P 500 which has returned ~19% during the same period.

In summary, develop a list of companies that are great and pay attention to when they miss or beat consensus earnings. Use the market's folly to your advantage to buy these companies at attractive prices when they miss earnings.