The Makeup of An Earnings Model Live Headline 23-May-03
Sell side research analysts spend hundreds of hours a year tweaking and improving their earnings models, all in an effort to get it right. But get what right? Which are the important parts of the earnings model and how is one really built?
The Earnings
An earnings model will of course highlight the amount of earnings per share a company is expected to make in the coming quarters, but most analysts will tell you that that number is simply a calculation based on all the other numbers above the bottom line. So that number is really just a fluid part of what happens after revenue and expenses are netted out. The other major variable in the equation is the number of shares outstanding, which is more often than not a number that is provided by the company.
The Hardest Part of the Model, and the Most Important The most important part of the model, and the hardest part to create is the top line, otherwise known as the revenue line. Most companies don't have a singular revenue stream, and if they do, there are surely several components from which it is comprised. What an analyst has to do, is look at how the company reports revenue and develop estimates for each revenue stream.
A fictional example would probably be best here, for the express purpose of keeping ideas in general terms. So let's say a company has three distinct revenue streams, each with their own line item when the company reports earnings. For each revenue stream, an entire spreadsheet (or possibly workbook) would be generated. It would likely break each quarter down into what would be most reasonable - that could be months or weeks or groups of weeks.
Analysts would employ every trick in the book to try to get the information needed to make their model work. But ultimately it comes down to following the segment of the market that he or she is covering with every bit of energy they have. Having a complete understanding of all the suppliers in the industry is key, as they will often give hints as to where their clients (the analysts' target company) are heading. Other things like trade publications and third party data providers will generally give information that will be integrated into a revenue forecast, but will likely hold little weight.
Working the phone is one of the best ways to get the important information an analyst needs to make revenue forecasts. Calling industry contacts or consultants and trying to get an overall feel for how the industry is doing is one of the best ways to forecast revenue. This certainly depends on the connections the analyst has, but there are always other ways of getting highly sensitive information. Paid surveys aren't used as much as they used to be, as employees have been trained not to tell company secrets since the introduction of Regulation FD (Full Disclosure), but they still provide some useful information.
When working closely with the company, the investor relations department might even do you the favor of giving you a contact at one of their major clients. When interviewing customers, analysts get an excellent feel as to why one product or service is doing better than another. They also try to find out who is in competition to replace the target company's goods or service. Customers are truly an invaluable resource and need to be rewarded for the information they provide.
Gauging the Costs
After an analyst has repeated the above process as many times as there are revenue streams, he or she can come to a final revenue number for the quarter. This revenue number will often be a guideline for the other line items, especially if it is a well established company where costs don't move around too much. After listening to industry contacts and doing the due diligence to find out what prices are doing, an analyst should have a good idea of where gross margins will be. If pricing has been strong (stable to rising prices), it is likely that margins will increase. If pricing has been weak, an analyst might model in lower gross margins.
An established company will generally have a fairly predictable cost structure. Nevertheless, most analysts will model out the number of employees and any other costs they can break out of the "SG&A" lines. The SG&A lines stands for Sales, General & Administrative. Promotion and Marketing expenses in the sales, or sales and marketing line, certainly provide for the most flexibility in making or breaking an earnings report. This line can provide a steep and sudden cut in order to make estimates.
All Important Guidance
While more and more companies are no longer offering the highly specific guidance they did in the past, certain companies still "coach" some analysts to where they would like to see estimates. Guidance is still a very important part of creating a model, as the target company has the best idea of anyone where most of the numbers will come in. The guidance is generated from a combination of how budgets are being spent and how results are coming along in the quarter.
The other side of guidance is that the analyst might feel he is getting low-balled by the company so that they can meet or beat estimates. Managing expectations is the job of the head of investor relations, and making sure that the consensus is reachable is his or her job. Often, they used to call analysts and try to persuade them that their estimates were too high. With Regulation FD limiting what companies can say to analysts, this practice is highly discouraged.
The Changes of Regulation FD
Regulation FD has changed the landscape significantly. Any changes in guidance must be given to all investors (or at least be made available to all investors) at once. Companies generally give guidance during earnings conference calls or during webcast events were everyone has access. Some companies go so far as to issue a press release that contains any of the guidance that may be repeated by senior management. Deep contacts within the industry probably still provide useful information to analysts, but it is getting harder and harder to gauge which employees at a company truly have a grasp of what is being spent and what is being earned.
In Summary
Models are very fluid things, as they are constantly changing and being updated. As the analyst learns more about the current economic conditions and competitive forces inside a specific industry, their model will be able to give a better snapshot of what the company is seeing. This, in turn, gives investors a good idea of what to expect in the future.
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