The eagerly awaited earnings season is back here, with Infosys, as always leading the early announcer pack with its second quarter results for financial year 2010. Market observers will now scratch their head with this and also with how the rest of coming seasons will go. Well, I am not writing this on Infosys and what we can expect from the market, but about the key actor in the earnings season. You guessed it right, it’s all about earnings.

Ever thought, why is an earnings season such an event in the stock markets? What does it really means, and why it is strong driver of stock price performance?

Because, stock markets are just conditioned to follow earnings based price determinants!

In fact, earnings are just one part of the overall scene. They are merely an accounting estimate for a particular period.

More than half of the share price performance is related to the sector it is in. The fluid nature of money keeps it flowing across different parts of the economy i.e. sectors at different times. If you are looking at relative long term impact on share price, the most important consideration is being in the right sector.

Let’s look at how this earnings game is played quarter after quarter.

The companies have to issue earnings and status reports as part of various statutes. They also write certain forward looking statements in their annual reports so that shareholders can understand the direction in which the business is likely to move.

But, for near term, they (management of the company) even go ahead and estimate their future profits, and try to paint “true and fair” picture of the current state of affairs. (Management Guidance!)

They “try” so because accounting principles and standards provides albeit some flexibility especially relating to alternative valuation methods, and unforeseen complications. (Window Dressing!)

This data is then provided to the stakeholders and other interested parties. The key processors of this data are the institutional investors. We know that these institutional investors determines most the direction of the market and the flow of money into (and out of) various sectors.

These "institutional investors," are the professional money managers (as what they claim!) and usually includes insurance companies, banks, asset management companies, and other similar bodies who control the investment to the tune of mega crores of rupees.

These institutions usually employ scores of educated individuals with high end qualifications and apparently coming from the most reputed business schools and universities. They create and undertake an in-depth analysis of economic models. These individuals are the ones who help institutional investors decide what to buy and sell, and when.

They churn the data further from the various corporate disclosures, and then come out with their own predictions by building the financial models that give a value to a company generally based on its historical performance. More often this historical performance is little bit extrapolated as the focus is near term. And in most of the cases, the basis or the focus of these models remain earnings. Various offerings emanate from it under the disguise of “Model Portfolio” which just simulates those financial models. As different analysts at different institutions try to value the stock, they make future earnings estimates to cover a broad range from low to high.

For most of the valuation, the starting point is the estimated earnings per share. (the number you get by dividing net profits by common outstanding shares) This earnings per share is also the denominator of another most popular multiple metric the Price to Earnings (P/E). (You get this by dividing the share’s current market price by its trailing twelve months earnings)

The stock is considered to be cheap, if it is available at a lesser P/E. That’s not to say it is good investment, as P/E needs to be looked always with growth possibilities in earnings. Earnings growth in excess of market expectations results in P/E expansion. (Rerating!)

Though the P/E is a company specific metric, market enthusiasts have also come out with Market or Index P/E.
Last year, for most part, the P/E ratio for the Sensex, based on trailing 12-month earnings, was around 13, one of its historic lows. Now it is about 21, few notches below its historic high.
Just a little bit deviation here for the benefit of readers. Though we may question the academic construction of market P/E, but it gives important investment insights. Here are some valuable facts for the BSE Sensex P/E. The normal range P/E range has been between 15 and 25. Whenever it has crossed the upper range of 25, markets have corrected with a sharp decline irrespective of nature of your stock holding (More for high beta stocks, less for low beta stocks). Similarly, every time it moved below 15, it was followed with a rise. This indicator may be worth looking now as it is inching towards its historic high. However, if trend prolongs (bearish or bullish) over a longer duration, there may be changes in the 'normal range'. Index can go up without affecting the P/E, if there is a corresponding increase in the earnings.

Coming back to earnings! Let's say an analyst finds that on an average a particular share trades at the P/E of 20. He does a little calculation and works out forward EPS at Rs. 6 per share. This means that this analyst would consider the stock a "Buy" at any price below Rs 120 (20 x Rs 6). If conditions turn out to be more favourable and he revises his earnings estimate at Rs 7, making his recommended target price at Rs 140.
Analysts raises the estimate, and the stock price generally follows!

Here’s how it went historically! In the last bull run, about half of the companies issuing earnings estimates met or exceeded them every quarter. These days, exceptions apart, it is quite uncommon to see a company meet or beat estimates that have been lowered. How was that possible?

The companies have realized that, rather than run the risk of not meeting estimates, it was always better to lower the expectations and then exceed them. Hence, they started giving these analysts figures that subdue their own expectations of earnings. This makes analysts to issue their own conservative earnings estimates. (they don’t have any crystal ball!) And it work for them also! How? Because it allows them to put far more "Buy" recommendations to their clients than "Sell" recommendations.

If an earning estimate gets raised, a lot of people pay attention. Those stocks are then likely to outperform the market. If it gets lowered, even more people pay attention. Of course, those stocks will likely underperform.

When actual earnings exceed or fail to meet the earnings estimate, it qualifies as a positive or negative "Earnings Surprise." Then, next quarter, it starts all over again.

In this market situation, the P/E is not what it should be. Many stocks have gained ground. This could be on expectation of improved earnings scenarios. Other than the global factors, if earnings are not likely to grow, it is advised to tread with caution. (Tune to any financial news channel, the most frequent word you are going to hear is “Cautious Optimism”)

But for long term investors, nothing to worry! Even if market turns tipsy-turvy, understand that ultimately things will settle, identifiable patterns will again emerge, and companies will start believing in their own earnings estimates.

Till then enjoy the ride and be disciplined with your stop losses!

Happy investing

source : http://www.hbjcapital.com/