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Saturday, September 4, 2010

Management Offering EPS Guidance

Markets are more often fixated with the EPS (earnings per share) guidances offered by company managements during the earnings season. The guidance is generally an indication of just the next three to nine months performance. However, investors tend to take them rather seriously. And by doing so expose themselves to some grave risks.

Offering conservative guidance and then outperforming them comes easy to large companies during high growth periods. But investors mistake such outperformance as perennial. And in the bargain, end up paying high valuations for the same.

Similarly, marginal underperformance during temporary slowdown often leads investors to lose faith in the business. This could rob them of a perfectly sound long term investment at even cheaper valuations.

But the risk of earnings guidance is even more profound in case of smaller or lesser known companies. Brokers hosting investor meets for lesser known companies during the result periods are commonplace. These typically serve as a platform for the companies to boast of unrealistic earnings estimates. The brokers in turn get a chance to popularize the stock in the street and generate more business. The only loser is the small investor who takes the guidance too seriously without checking more critical data points. And this, we fear, leads to most of them lose faith in stocks forever.

A good earnings season, like the one just gone by, is therefore a critical test for long term investors. It tests his or her ability to separate the wheat from the chaff. As also the ability to ignore near term promises and keep an eye on long term values.