How important are earnings expectations?


By Admire Mavolwane



EXPECTATIONS are a powerful force that everyone has to deal with all the time. Matters are compounded by the fact that expectations translate into perc

eptions and then into reality. World over one issue, among others including their image, that worries leaders of listed companies is how much the “know-all” analysts expect their company’s earnings for the upcoming reporting period to be.


The share price performance ex-ante and ex-post publication of results depends to a great deal on this subjective notion of analysts’ expectations. As such, it is every executive’s wish to at least match the collated analysts’ expectations, especially the average earnings forecast which in other jurisdictions is termed the “consensus” earnings per share. Outperforming the “most optimistic expectation” is a dream come true for many in the same way as underperforming “the most pessimistic expectation” is a nightmare.


In the developed world, especially in the United States, this animal called analysts’ expectations — or Wall Street projections as they would call it — had in the recent past grown in importance so that it was in a way beginning, rather unfairly, to affect executive remuneration structures. It was fast becoming a yardstick for measuring an executive’s success.


Many an executive profile or curriculum vitae would include a section that would detail the progress of a company’s market capitalisation during their tenure in office. There is a direct link between the share price and market capitalisation, hence a firm price means improved market capitalisation, obviously keeping the number of shares in issue constant.


An off — shoot of this was the development of earnings management as a concept. Some of the scandals at Enron, Worldcom, TYCO and a number of earnings over statements were in part driven by the desire to exceed or match projected earnings from Wall Street.


As most managers became shareholders in the companies they were leading, through management buyouts or share options, the obsession with analysts’ expectations became even stronger.


In the US, the most used method had to do with accounting of derivative instruments. Locally, market watchers have voiced their concern about the application of accounting standards, IAS40; revaluation of investment property and IAS41; revaluation of biological assets. Some would argue that companies always disclosed the contribution of the fair value adjustments to earnings but people remember the final figure and not always its make up.


Why would an executive running a business, who knows more about it anyway, lose sleep over what young analysts and — as one local insurance executive would put it — think about how much the company should make? The main reason is that investors in general gullibly take advice from analysts based on the analyst’s own earnings expectation. If the analyst is bullish about the company, he/she will influence the client to buy while the converse is true.


The stock market also works on a reward and punishment basis. Companies whose results exceed market expectations are immediately rewarded with uplift in share price. Those failing to measure up, as it were, get punished. Analysts would then say the price is correcting to reflect the earnings.


In other words, the price is now bridging the expectations gap. The after-results share price performance of those companies that perform in line with expectations depends to a large extent on the story that management would have sold the market. If it is downbeat, selling pressure overwhelms buying momentum. The opposite applies when it is very upbeat.


One company whose results, in addition to those of Delta, Meikles, Art, CBZ, Innscor and Econet, are keenly followed by the market, is CFI.


Ever since the company’s remarkable recovery from loss making to profitability management has had to grapple with investor expectations. The share price always runs ahead of the release of results as punters take positions anticipating windfall gains as the counter re-rates after once again surprising the market. In the weeks prior to the release of the final year to 30 September 2006, the company sprang from a low of $50 at the beginning of the month to a high of $120 per share on Wednesday close of trade.


At the briefing a lot of rather disappointed faces could be discerned among the participants from the analyst community. The group had only managed an EPS of $9,56 which was outside the analysts forecast range of $13 to $16, mainly on account of management having seen fit to revise the method of estimating the value of biological assets for fair valuation adjustment purposes.


In the last reporting period, contribution to revenues and operating profits of biological asset revaluations had risen to as high as 41%. The subsequent change in the estimation method saw the contribution shrink to 10%, thereby throwing out most analysts’ projections. But numbers are numbers whatever the reason for underperformance. So the share price got punished, declining from $120 to $100 and looks set to continue sliding.


In brief, turnover grew by 927% to $20 billion, with the poultry division contributing 49%; the retail operations 21%; and the specialised division, 18%. Being a conglomerate, the volumes performance was mixed depending on product lines.


Operating profits grew eleven times to $6,8 billion, on the back of a three percentage point margin improvement to 34%. Access to approximately $450 million worth of concessionary ASPEF funds saw the interest bills rising modestly by 226% to $126 million. Attributable earnings grew in tandem, thirteen — fold to $4,9 billion. The return compares favourably with average year-on-year inflation for the period of 870%.


The numbers were respectable but nowhere near exceptional, which was what CFI had become associated with- sort of reminding many of the NMB and Trust in the old days — hence the canning of the share price. But what many in the market forget is that the performance was coming off a low base.


Delta, with earnings per share for the six months to September 30 2006 of $9,96, beat all expectations which where range bound between $5,02 and $8,63 and the price has been on a roll. The corporation’s market capitalisation rose from $428 billion to $652 billion or in US dollar terms measured at the parallel market rate, from US$214 million to US$326 million, all in one week. What would have happened to the share price had the analysts range had been from $9 to $11 or had started off at $10? A point to ponder!