Brokers like to play the game of “beat ratios” in which they talk about how many companies are beating the estimates for earnings this quarter, and hence why now is a good time to buy stocks.
Oddly enough, the beat ratio appears never to have a negative implication. This rather amazing tendency to optimism reflects in part the Street’s constant adjustment of expectations. Typically the beat ratio is calculated on the basis of the estimates that are available immediately before earnings are announced and these estimates are almost always below the ones made a few months earlier.
Investors who want to understand how the game is played should read John Hussman’s piece on reported earnings vs owner earnings. The founder of Hussman Funds has a nifty chart going back to 1973 that demonstrates how one-year-forward expectations for S&P 500 operating earnings compare with actual reported net earnings.
There is a rather large gap between the two. Actual net earnings have averaged only about 72% of what the pros had estimated for operating earnings a year ahead of time.
But wait — there’s more. Or less, as it turns out. Actual net earnings are further diluted by events such as stock options granted to employees.
The money that actually winds up in shareholders’ pockets, either through dividends or through changes in book value, is less than either expected earnings or actual earnings. In fact, these “owner earnings,” as Warren Buffett likes to call them, average only 60% of forward estimates of earnings.
Hussman’s conclusion is that investors should take a close look at how much companies generate in owner earnings because that is the only cash that will actually be delivered to shareholders over time. “Everything else is hype, smoke and mirrors,” he says.
Freelance business journalist Ian McGugan blogs for the Financial Post.