The Power of a Penny

April brings flowers and baseball. But it’s also a frantic time for anyone in the investment business, as companies with a fiscal year end of December 31 start to report their first quarter earnings.

As I wrote in Money Grab, this can be very stressful:

Companies that beat Wall Street analysts’ estimates could see their stock price soar. Those that missed, even by a penny, faced major downside risk. Getting our clients’ portfolios correctly positioned before the earnings release meant the difference between beating our benchmarks and lagging painfully behind them.

So how does this process work? And why is missing by just a penny such a disaster?

Wall Street analysts constantly talk with company managements to share their expectations for upcoming earnings. If the company feels the analyst’s projections are too high, management might suggest dialing back on future revenue growth or lowering operating profit margins, to bring the estimates down. Savvy managements know it is always best to under-promise and over-deliver.

Earnings are reported on a per-share basis. So, if a company has 500 million shares outstanding, and the estimate is for $2.75 in earnings per share, then the expectation is that the company will earn $1.375 billion. If the company misses by a penny and earns only $2.74 per share, then that is total earnings of $1.370 billion. That one penny miss has suddenly turned into a $5 million miss.

More important than the actual dollar amount of the miss, however, is the signal that it sends to shareholders. Those who bought the company for earnings growth will be disappointed. They are likely to sell this stock and look for another one that better fits their expectations. That selling pressure will push the price of the stock down, causing investors to lose money and portfolio managers to underperform their benchmarks.

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