analysts

Why your stock just tanked

July 21, 2010: 2:41 PM ET

I met my friend Martini for a drink and right away I could tell he had his funk on. He was scowling into his namesake beverage as if he were looking into the bottom of the market, circa October 2008. "Hey, Bob," I said, easing into the spot next to him and waving away a tendril of black ooze from his aura. "What's the matter?" And so he told me.

You know what happened in the World Cup between the U.S. and Slovenia, when that bonehead from Mali declared a phantom foul and robbed Team USA of its go-ahead goal? How about the moment this spring when the Tigers were playing the Indians, and the umpire blew an easy call at first base to despoil the pitcher's perfect game? One numbnuts doing his job improperly can bring ruin. And so it was with Martini and his company, which had just announced second-quarter earnings.

"We had a great quarter," he said, draining his glass and motioning for another. "Revenue up high single digits. Operating income through the roof. Huge EPS."

"So?" I asked.

"So," he spat out. "We missed consensus by a penny."

"How'd that happen, Bob?" I inquired. But I knew. It was the fault of yet another renegade, lazy securities analyst.

"Consensus was right on the money," said Martini. "Except for one outlier at this tiny little firm." He named the firm. I'd never heard of it. "Ed Wormer," he said. Of course that's not the name he actually used, so if your name is Ed Wormer you can back off. "Everybody else had our EPS at 27¢ a share. Wormer had it at 54¢."

"That's an overestimation of 100%," I observed.

For those lucky enough to work in a private company, or unlucky enough to not care about your stock price, I will explain. Wall Street employs a legion of analysts to assess and guess how companies will perform throughout the year. As with any profession, the cadre is stocked with individuals of uneven quality. Some do their jobs carefully, working with the Investor Relations guys at each firm they cover, who are under very tight constraints on what they can reveal, to make sure they don't get things completely wrong. Others seem to exist mostly to give interviews to financial reporters. (We call those "quote monkeys," and they know who they are.) And there is an odd bunch who don't know their spreadsheets from a hole in the ozone layer. They add up columns wrong. They mistake billions for millions. They're morons. And yet they go on. And they matter.

They matter because four times a year Thomson Financial aggregates all the analysts' estimates and issues a consensus on earnings for each company, whether it wants one or not. This is called the First Call, and reporters use it to judge whether a company had a good quarter or not.

And so that day, Ed Wormer's outlandish estimate that Martini's company should have earned 54 cents per share that quarter was factored into the First Call, and it tipped the average consensus, and so the headlines on the wires that morning did not talk about great revenue, terrific operating income, or even excellent EPS, but rather said Martini's company had "missed consensus by a penny."

"We went down 8% in the first half-hour after the opening bell, which brought out the shorts, and the rest is history," said my friend.

"Maybe you should have spoken to Wormer beforehand," I suggested as gently as possible.

"Of course I did!" he exploded. "You know I can't give him any specifics, but I asked him if he wanted to embarrass himself with his EPS number, and he said no, that he'd run his models again!" I let the silence hang. "Which is when he went on vacation," Martini said.

So the next time you look at your stock portfolio, or talk to your broker, or read the papers, consider the foundation upon which our economic system is based. And then, I think, go to Vegas. At least what happens there stays there.

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