Money & Finance - The Earnings Puzzle

As we head into the close of the second quarter, it’s time to start talking about corporate earnings.  On a twelve month-forward basis, analysts are expecting the S&P 500 to produce $116.54 in earnings placing the 12MF P/E ratio just above 14x. Using a blend of historical multiples, one can easily put a fair market value for the S&P 500 near 1605. While this multiple is not alarming at first glance, digging further into the data reveals a few cracks that could further hurt the market.

 

 

The Earnings Puzzle?

The chart below shows quarterly earnings ex-items for the S&P 500. The last two columns are analysts’ forecasts for the coming two quarters. One can obviously see the trend is positive and is expected to continue that trend into the near future. These higher earnings forecasts certainly justify higher stock prices if corporate America can produce these results.

That may be a bit difficult when you look at revenue trends.  Year-over-year revenues have been declining over the past few quarters. If fact, given current forecasts, in order for the S&P 500 to hit its earnings mark, net profit margins will need to increase to 10%. Bear in mind this is an extremely high level and one that will be difficult to accomplish. 

 

 

Confessions.

One can also see trouble brewing as it relates to corporate preannouncements. 

Lance Roberts writes in his piece, Earnings Season Set To Disappoint “Companies haven't even started posting second-quarter earnings results yet, but the early picture isn't pretty.  The pre-earnings season is often referred to by market insiders as the "confessional"—that time when Corporate America starts letting shareholders know the truth between earnings perception and reality.

If this quarter's version is a reliable indicator, there will be some serious penance handed out once announcements officially begin in two weeks.  Earnings pre-announcements have been decidedly ugly, running about 7 to 1 negative to positive.

That's the worst level since the first quarter of 2009, when, in the words of Citigroup chief strategist Tobias Levkovich, 'the global economy was sitting on the edge of the abyss undergoing a financial crisis and near systemic meltdown.'"”.

http://www.streettalklive.com/daily-x-change/1743-earnings-season-set-to-disappoint.html

So revenues and revenue growth is slowing yet analysts are still expecting record earnings results. 

 http://www.streettalklive.com/daily-x-change/1743-earnings-season-set-to-disappoint.html

Earnings Quality.

Suppose we had two companies, Company A and Company B. Both are expected to earn $1.00 per share on $10mm in revenues. One would think them identical but that may not be the case. One needs to analyze the quality of earnings to get a clearer picture. Let’s suppose the “cash” component of company A is $0.80 and the “accrual” portion is $0.20. This means that of the $1.00 in earnings that is reported by company A, $0.80 is accounted for and collected as reflected on the cash flow statement and $0.20 is reported but not yet collected.

Now suppose the “cash” component of company B is $0.20 and the “accrual” portion is $0.80. Clearly there is a much greater risk of an earnings miss by company B.

 

Possibly the companies in the S&P 500 can meet these earnings projections by “borrowing” from future quarters to meet the current quarter. If that were to be true, then we would see deterioration in the earnings quality for the index.

After running our model to capture earnings quality for the index, we found that to be the case. Since 3Q09, earnings quality has been breaking down and last quarter entered the “low earnings quality” area.

This may be another reason there has been so much downward guidance for the coming quarter.

 

Bottom Line: With the Fed stepping away from its QE mission (albeit slowly), we may see the market start to focus on more traditional, fundamental measures of multiple expansion. If that turns out to be the case, we may see further downside in the market.

- Joseph S. Kalinowski, CFA

Twitter: @jskalinowski 

 

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