Warren Buffett on Earnings expectations (2005)

Buffett shares his thoughts on earnings expectations in stocks.

A company's earnings are its after-tax net income. This is the company's bottom line or its profits. Earnings are perhaps the single most important and most closely studied number in a company's financial statements. It shows a company's real profitability compared to the analyst estimates, its own historical performance, and the earnings of its competitors and industry peers.

Earnings are the main determinant of a public company's share price because they can be used in only two ways: They can be invested in the business to increase its earnings in the future, or they can be used to reward stockholders with dividends.

Earnings are the profit that a company produces in a specific period, usually defined as a quarter or a year. After the end of each quarter, analysts wait for the earnings of the companies they follow to be released. Earnings are studied because they represent a direct link to company performance.

Earnings that deviate from the expectations of the analysts that follow that stock can have a great impact on the stock's price, at least in the short term. For instance, if analysts on average estimate that earnings will be $1 per share and they come in at $0.80 per share, the price of the stock is likely to fall on that "earnings miss."

A company that beats analysts' earnings estimates is looked on favorably by investors. A company that consistently misses earnings estimates may be considered an unattractive and risky investment.

There are exceptions to these outcomes depending on the circumstances of the company. For example, Amazon (AMZN) missed its estimates for several quarters in the early 2000s while it was building out its various business units. Some investors were able to understand the long-term potential, and it continued to attract investors.

Generally, a new, entrepreneurial company that is seen as having strong potential can survive a few disappointing quarters, though it generally needs a good explanation for the earnings miss. As was the case for Amazon, that explanation was a heavy investment in future earnings.

Since corporate earnings are such an important metric and have a direct impact on share price, managers may be tempted to manipulate earnings figures. This is both illegal and unethical.

Some companies attempt to sway investors by prominently displaying their earnings on their financial statements in order to hide deficiencies reported lower down that reveal weaknesses like dubious accounting practices or an unanticipated drop in sales. These companies are said to have a poor or weak quality of earnings.

The earnings per share number may also be inflated with share buybacks or other methods of changing the number of shares outstanding. Companies can do this by repurchasing shares with retained earnings or debt to make it appear as if they are generating greater profits per outstanding share.

Other companies may purchase a smaller company with a higher P/E ratio to bootstrap their own numbers into favorable territory.

When earnings manipulations are revealed, as in the case with Enron or Worldcom, the accounting crisis that follows often leaves shareholders on the hook for rapidly declining stock prices.

Buffett Books:
Intelligent Investor: https://amzn.to/3cY7rTP
Warren Buffett: 43 Lessons for Business & Life: https://amzn.to/3lMvjOf
The Essays of Warren Buffett: Lessons for Corporate America: https://amzn.to/3ccnIFy
The Snowball: Warren Buffett and the Business of Life: https://amzn.to/3vROoTM
The Warren Buffett Way: https://amzn.to/2NITWii
Buffett: The Making of an American Capitalist: https://amzn.to/31b3FkM
Security Analysis: 6th Edition, Foreword by Warren Buffett: https://amzn.to/3cbcbq7
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