Consensus Estimates Don’t Matter

Here’s another interesting nuance I came across in the work of McKinsey & Co. and their co-authors, which I want to share with you:

Investment platforms for securities typically display analyst ratings/forecasts. The median “consensus estimate” is often highlighted, primarily concerning EPS (Earnings Per Share).

The issue is that companies strive to meet analysts’ EPS forecasts through short-term measures, which actually harm long-term interests.

Below is a graph showing the results of a survey of 400 CFOs. The question posed was: What would you do at the end of the quarter if you saw that the organization was not meeting profitability targets?

Interesting Statistics:

A 25-year study of the S&P 500 shows that from 1995-2009, there were only 7 years when the forecasts were within 5% of the actual results, while for 18 years, the deviation was more than 5%; furthermore, in 16 of those 18 years, the actual figures were lower than forecasted… In other words, the average ratings were “overly” optimistic.

Even More Interesting Statistics:

The analysis of “earnings surprises” shows that in 40% of cases where the surprise was positive (negative), long-term profitability actually decreased (increased)…

Additionally,
The analysis of 595 European companies in 2007 shows:

When organizations met current profitability targets, but analysts lowered long-term ratings, stock prices fell by an average of 0.6%, while when organizations missed current profitability targets but analysts raised long-term ratings, stock prices rose by 1.6%…

In other words, the market only values achieving quarterly profitability if it is seen as sustainable in the long term.

Source:

Value: The Four Cornerstones of Corporate Finance
by McKinsey & Company Inc.,Tim Koller, Richard Dobbs, Bill Huyett