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Yahoo U: Earnings Estimates

Yahoo Finance’s Brian Cheung joins the On the Move panel to discuss this week’s Yahoo U: Earnings Estimates .

Video Transcript

ADAM SHAPIRO: Welcome back to "Yahoo Finance, On the Move." we've got the S&P 500 up 16 points. Dow is up almost 230 points. And NASDAQ's up more than 16 points. We like to call him Sammy Hagar, but his real name is Brian Cheung. He's here for the latest installment of Yahoo U to tell us about earnings estimates and what they truly mean as we go into earnings season.

BRIAN CHEUNG: Thanks, Adam. Well, happy earnings season, and you'll hear all the time that earnings beat, or they missed estimates, which begs the question, whose estimates? I mean, they don't come from a store. They don't rain down from the sky. They come from analysts whose entire jobs are following certain stocks. And those analysts often have their own models to estimate how companies will perform in their earnings.

Now we get a lot of these earnings from a cert-- from aggregators, and let me just illustrate that right now, if I could pull up my slides here really quickly. And here they are. So there are aggregators like Bloomberg, S&P Capital IQ, Refinitiv, in addition to FactSet. And these services collect the Street's various estimates and then combine them into what you'll hear as a consensus estimate.

So what figures do they look at? Unfortunately, I need to take you through a brief accounting lesson, and this is a fake income statement. But it shows you on the top the revenues, right? This is the amount of sales of shoes, pants, what have you. Of course, they call it net revenues because it accounts for any returns or whatever.

And this is what they call the top line because it's the top of the net income statement. And then the companies obviously have to pay the bills to keep the lights on. So expenses are going to come out. And then you have the bottom line, the net income. This represents the money that you have really made in the quarter.

Now earnings per share adjust this bottom line for the amount of shares out there, which kind of gives you an idea of the potential return to each individual shareholders. So these two figures, net revenue, the top line, in addition to earnings per share, the bottom line, are the critical performance metrics which analysts like to use to guess how a company is going to perform.

Now over the course of three months that cover a single earnings period, a lot can change. So here's an example. On Tuesday, we got the third quarter results for JPMorgan Chase for 2020. And the stock price on this chart is illustrated in blue. And purple represents the Street's estimates for earnings per share.

So you'll see that the Street often lobs these estimates years ahead of time. So as we headed into the end of last year, people were saying, OK, here's just a number that we're going to throw out there for the third quarter of 2020. And those estimates were mostly steady until, boom, right, the COVID crisis.

And analysts started sharply revising down their bottom line expectations for the company. And this is understandable, right? Banks are the heart of the economy. The economy was getting battered. Analysts were saying, you know what? I'm not so sure about the ability of JPMorgan Chase to beat some of these expectations. So they just simply lowered the bar.

But you'll notice what happened in June and July. They started revising up their expectations as they got into these second quarter earnings results for this company. Because it seemed like the economy maybe was rebounding a bit faster than they had expected.

They kept those expectations kind of steady as we got into the middle of the third quarter until you saw, right before they reported their earnings, they raised their expectations again. Maybe it's because they saw some economic data. They said, hey, you know, JPMorgan Chase might actually be doing even better than we thought.

So this shows you in summary how the bar for beating or missing the Street's estimates are very dynamic. And they're very consequential, too. Now this that I'm showing you is slightly outdated data. It comes from 2014 from Refinitiv, but it shows you some really interesting points that I want to show you.

So this maps out the stock market performance of S&P 1,500 stocks the day after reporting their earnings, relative to the broader index. And this is pretty intuitive, right? If you beat both estimates on the top and bottom line, you'll see that investors tend to reward you with a little stock bump. But if you miss both, you're going to get a little punished. That all makes sense.

But there's two important details here. If you only beat on the bottom line, right, the earnings per share, you don't really get rewarded all that much. It's kind of like you just met the bare expectations. But if you beat only on the top line, but you don't manage your expenses that well, and you miss on the bottom line on earnings per share, you're still going to get punished. So this is the treatment from the Street that's worth mentioning.

And the second point I want to make is that this is also stratified by company size. Purple represents small cap companies. Blue represents large cap companies. And if you're investing in a small cap company, you'll notice here that if you beat both estimates, you're going to outperform on the day after an earnings beat. But you will also suffer more outsized losses if they miss. So it's kind of win big, lose big when it comes to these smaller companies.

Now, of course, top line and bottom line aren't the only estimates that matter. So analysts have estimates for everything that you could imagine. Think about the growth stocks, right? Tesla analysts pore over unit sales for any given model. If you look at the ridesharing companies like Uber and Lyft, gross bookings is a critical metric. For streamers like Netflix, and now Disney Plus, video subscribers are critical. So analysts always have metrics for these.

Now it's important to remember that when thinking about all of these types of earnings estimates, it's all about setting expectations, right? Those expectations can move. Those expectations can be different across industries and even across size. But most importantly, those expectations also have a pretty heavy weight on the reaction of a stock, which is worth thinking about if you are trying to invest. Julie, Adam.