Why The Quarterly Estimate Game Is Far More Than Short Term Thinking For Investors

I saw a tweet this morning in the search feed for Estimize that represents a certain line of thinking I’ve heard over the years which is incredibly misinformed. I’ve been meaning to write this post for a while and just never get around to it, but it’s an important one.

“Estimize is just another representation of the extraordinarily short term focus of market participants.”

The number of hours wasted by humans bemoaning (wrongly) the focus on the quarterly earnings “game” is innumerous. These individuals, who run the gamut from individual investors to the largest asset managers in the world, hold a certain dogmatic view, mostly of the efficient markets flavor. The short term focus the tweet above ascribes to Estimize is obviously of the negative variety (then again, have you ever heard anyone use short term and investing in the same sentence in a positive way?).

So why is this line of thinking incredibly flawed? The answer is pretty simple.

At the end of the day the entire market is a forward looking mechanism. All information about a company or its stock available to the market today will be used (inefficiently) to project where a company and the supply/demand for its stock is headed in the future. Investors inherently DO NOT CARE exactly what a company earns today, that is not how assets are priced. This is where the people who espouse views like the one above are simply lazy or naive in their thought process.

What a company earns this quarter is incredibly important to understanding what it will earn next quarter, next year, and 5 years from now. Each earnings report gives us clues as to the trajectory of a company’s business, which at the end of the day is the most important piece for being able to discount the future into some price you’re willing to pay for the stock today.

The game of quarterly estimates is simply the manifestation of what investors have discounted into the stock in terms of expected fundamental performance. You NEED to understand what expectations for a given company are in order to understand what is baked into its price. Now, the reason we built Estimize was that the number everyone was looking at to represent what was baked in was basically a lie. The sell side was making artificially high estimates going out a year or two and then bringing them artificially too low right before the report. Investors couldn’t really get a great read on what was actually baked in by looking at these numbers because they were a sham. That’s why hedge fund analysts will call around to each other to find out what their peers really expect and triangulate what’s actually baked into the stock. Estimize solves that problem for them by making that collection process more efficient and accurate.

But here’s why a company beating or missing their consensus estimates is really important, not just for the short term, but especially for the longer term.

Let’s say that company XYZ trades today at 10 times forward 1-year revenue estimates with a market cap of $10B. The last four quarters the company has reported 35%, 37%, 40%, and 40% YoY revenue growth, some pretty great numbers. The company certainly has a high revenue multiple, but deservedly so as it’s growing quickly. This coming quarter the consensus expectation is for the company to grow 40% YoY again, and the market has treated the stock well based on this, it’s up 10% this quarter, continuing to trade at that same 10 times revenue multiple it did last quarter.

And here’s where those expectations get REALLY important. The company doesn’t execute well, or one of its product lines doesn’t sell as well as expected, or something else goes wrong and growth slips to 34% YoY. What do you think is going to happen to that rich multiple?

If the multiple doesn’t change, the difference between that 34% YoY number and the 40% YoY expected is a few percentage points of appreciation over the next quarter that the stock won’t see, but it’ll still be up 7-8%. But that’s not how the market works. The price of any stock is dependent on two variables, some fundamental number (EPS, Revenue, EBITDA, monthly active users (god help us)), and the multiple that investors are willing to put on that number. Both of these can and will move dramatically and you need to have a view on both.

The movement in the multiple is highly dependent on the trajectory of growth for that fundamental number. Company XYZ just slipped on a banana peel and had no room for error at that multiple, and over the next quarter it may now fall from 10 times forward to 7 times forward, which means a 30% cut in the stock’s price before you factor in the 7-8% growth in the fundamentals. So you basically just took a 20%+ hit to your stock because investors felt that this quarter’s report gives new information about the future trend of the fundamentals and they are no longer willing to support the stock at that multiple.

Good luck if you’re not paying attention to the estimates and how a company reports the quarter against them if you want to understand what’s going on in the stock today and in the future regarding the multiple, which in many cases can be the more important factor in both momentum names and value names. You are basically playing with one arm behind your back if you’re ignoring this.

There is an old saying, stocks take the stairs up and the elevator down. The elevator down doesn’t happen because stock XYZ slipped from 40% YoY growth to 34%, it happens because the multiple gets cuts within days/weeks from 10 times to 7 times. And this happens because the expectations baked into the stock’s price (and multiple) were not met.

Is understanding what the market is likely to reprice your stock at in terms of the multiple over the next few years “short term focus”? Good luck burying your head in the sand come earnings time for the companies in your portfolio.