Wall Street can handle good news and bad news, but it has a tough time stomaching surprises.
Maybe that's why stock prices--and public confidence--can jump or tumble based on how well a company meets analyst expectations.
In fact, meeting expectations is often more important in shaping public and investor opinion than a company's ability to beat last year's profits.
"What a company doesn't want to do is be known as someone that surprises the Street all the time," says Todd Pulvino, assistant professor of finance at Northwestern University's Kellogg Graduate School of Management, Evanston, Ill. "They're trying to manage expectations."
In an efficient market, expectations of a company's performance already are incorporated into a stock's price, Pulvino says, so it takes new information to boost or depress the stock price.
Take the latest round of hospital earnings reports for the quarter ended March 31, for example.
HCA--The Healthcare Co. (formerly Columbia/HCA Healthcare Corp.) and Quorum Health Group both reported lower profits. Quorum's net income fell 6% to $17.3 million compared with the year-ago quarter. Columbia's dropped 8% to $296 million (May 1, p. 22).
But stock prices for both companies rose the day the earnings figures were released. That's largely because investors had anticipated the results beforehand. Quorum's earnings per share were in line with analysts' consensus estimates, and Columbia's exceeded the consensus estimate by 7 cents per share.
By contrast, Brentwood, Tenn.-based Province Healthcare saw its stock price decline after it reported that earnings per share jumped 28% during the quarter. Analysts had expected the results, so the good news didn't prompt a run-up in the price.
High stock prices mean cheaper capital for the company and greater financial rewards for managers and employees, whose retirement benefits are often tied to stock performance.
"We've met expectations in every quarter since we've been a public company," says Merilyn Herbert, vice president of investor relations for Province. She questioned why the stock market would react negatively to a company with a good earnings track record announcing a strong quarter. "Does that make any sense?" she asks.
With a hospital company, investors should pay attention to consistency in admissions and revenue growth rather than judge the company solely on whether it meets estimates, she says.
But that's exactly what many investors do, according to Charles Hill, director of research for First Call/Thomson Financial in Boston, the firm that collects analysts' estimates and distills them into the so-called consensus estimate.
"Theoretically, (the estimate) shouldn't count for as much as it does," he says. Investments should be made on longer-term factors, Hill says.
Over the past six years, 57% of companies beat expectations, says Joseph Cooper, a senior research analyst at First Call. Only about 26% fell short, and the rest have just met expectations. On average, companies beat expectations by 2.8%.
Some companies communicate regularly with analysts about their earnings estimates, while others are not as forthcoming. Most analysts equate accurate earnings predictions with savvy management. But inaccurate predictions aren't always bad.
RehabCare Group, a contract therapy and staffing company based in St. Louis, released a first-quarter report in May that beat analyst expectations by an unheard-of 13 cents. Traders rewarded the company by driving the share price up by $4.38 to $34.75 that day. To be sure, net income had jumped 64% from the year-ago quarter, to $5.6 million.
But that wasn't what was prompting traders' interest in the stock.
"Any company is not going to be as aggressive in the numbers they give Wall Street as they are in their internal projections," says Rob Mains, an analyst for Hartford, Conn.-based Advest, who is bullish on the company.
"But I think these numbers beat their internal expectations as well."
While beating estimates can be good, First Call's Cooper explains that it is not in a company's best interest to regularly beat the consensus estimate by more than a penny or two.
"Somewhere along the line, someone figured out it would be a good idea if they beat estimates," he says."But once you establish a pattern of beating the estimates by a certain amount, you establish a false bogey."
This pattern will often end up leading analysts to rely on what is called a "whisper number," or a number higher than the estimate based on the company's projections.
If a company exceeds the consensus estimate by a lot, the company may not be providing accurate information to analysts, management may not have a handle on what drives the company or one analyst may be off base in calculations.
"Certain companies have certain earnings momentum and so there's a pattern or history of beating the number, so that then becomes the expectation," says Andrew Bhak, a healthcare analyst at Morgan Stanley Dean Witter. "It becomes not quite a game, but everyone recognizes it for what it is."
It is the job of the investor relations director to "manage" earnings expectations, Bhak says.
Still, meeting Wall Street estimates is not enough in and of itself to drive a company's stock way up.
Skeptics might suspect companies of low-balling just to hit the target if they always meet expectations.
But Bhak says not much is worse than missing a consensus estimate.
HealthSouth Corp., the nation's largest post-acute care company, has twice cushioned the impact of missed earnings targets by letting investors know in advance that it might not meet analyst expectations.
Announcements in September 1998 and in 1999 spooked investors into selling off shares. When the company released the disappointing earnings a few weeks later, share price hardly budged.
What matters, analysts say, is future earnings, not past performance.
"Everybody knows already that year over year there's a drop," said Debra Lawson, an analyst for Salomon Smith Barney, after HealthSouth announced a 41% drop in net income, to $65.3 million or 17 cents per share, for the first quarter ended March 31. The stock price dipped only 6 cents to $7.94 the day after the announcement.
What matters is whether the company can predict its performance reliably for the coming year without having to pop the bubble of investor expectation each autumn. "It's getting past that psychological barrier of the third quarter that will be tough," she says.
First Call's Charles Hill says that estimates can be a quick fix for the investor who is trying to get a handle on a company. "You really should be looking at the longer-term fundamentals," he says. "But psychologically, here's some way I can get instant gratification as to whether this company is performing well or not."