When a company announces quarterly results, a key market-moving factor is the earnings or the profit estimate. Companies promise performance and set market expectations. Analysts, who track these companies, use these estimates to form a benchmark for tracking the financial performance of a listed company.
Most companies in India and around the world follow the same practice. It started in the US and is now common in markets around the world. A new debate sparked off in the US is likely to usher in changes.
Warren Buffett, the famous American investor and chairman of Berkshire Hathway, a diversified US company, wrote an article in the Wall Street Journal along with Jamie Dimon, chairman and CEO of JP Morgan, a global bank. The duo called for doing away with companies making an earnings estimate.
In the US, it is usually based on the earnings per share or EPS. This is the net profit per equity share of the company. So when the company announces results, it either meets the EPS estimate or falls short of it. In India, it is the overall net profit and revenue growth guidance that is revealed by the corporate management. Share prices of companies have moved in tandem with estimates of companies.
Messrs Buffett and Dimon argue that quarterly earnings per share guidance drive businesses away from long-term investments. They say that companies hold back technology spending, hiring and research to meet quarterly earnings forecasts. The immense pressure to perform every quarter is forcing many companies to avoid public listing in the US.
A lot of retirement savings depend in the US on the long-term growth in the stock market. If fewer companies go public, this could mean lesser opportunities for ordinary investors to invest and save for retirement. In India, the government has recently allowed provident funds to invest in equity markets. A lot of retail investors are taking an exposure to equity markets through systematic investment plans in mutual funds.
The issue assumes significance. Investors need to watch out for all the commentary given by the management on the outlook for the future that is not limited to a quarter. Equity investing is after all about the long-term.
Indian IT services companies were perhaps the first to talk about earnings estimates in the 90s. A lot of information is released every quarter by managements in their statements to the press and analysts.
At one point in time, people got so used to Infosys profit guidance that they were shocked when the management lowered it once. The share price nosedived like never before.
It is important to set the context right for expected profits. Besides giving out estimates, company managements also speak out about the business environment they operate in. They give a lot of reasons for arriving at that estimate.
Most people find looking at the estimate given by the company for profits easier to understand. This is because there is a belief that managements tend to take into account all aspects of the business before putting out any profit guidance. However, experience suggests that small investors need to appreciate the importance of connecting the dots. There is a lot more behind the profit estimates given by companies.
For example, if you read conference call transcripts after a quarterly result of Maruti Suzuki, analysts ask a lot of questions to the management about the demand for cars in urban and rural India.
The management provides a lot of insights on the reach of the company and new trends. If the overall growth in the Indian economy remains intact, the company could perform better. However, if the economy slows, the company may reveal a strategy to maintain the strong growth through increased discounts.
Similarly, knowing more about global luxury cars matters for Tata Motors. The Jaguar Land Rover business of Tata Motors brings in most of the company’s profit. Hence, any new insights the company provides on markets in China and elsewhere for luxury cars would matter. If the demand for luxury cars is strong world over, Tata Motors could rake in more profits. However, if demand for luxury cars slows then profit growth could slow in tandem.
It is time for small investors to know about reasons behind estimates. A long-term investment perspective always helps when it comes to equities. Warren Buffett has emphatically proved that over the years.