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Are Investors Expecting too Much From Earnings?

April 15, 2011 By Jeremy Jones, CFA

Alcoa kicked off the first-quarter earnings season this week with a big thud. The aluminum producer reported strong earnings, but Alcoa shares dropped as much as 7% following the announcement. Earnings per share exceeded consensus estimates, but the top line came in below expectations.

Has the two-year, 100% bull move in stocks raised investor expectations to unrealistic levels? I’m sure Jamie Dimon (the CEO of J.P. Morgan) thinks so. On Wednesday, J.P. Morgan reported first-quarter earnings of $1.28 per share compared to estimates of $1.15—that’s a huge earnings beat, but the stock is down since the announcement. Apparently, investors were unhappy with the source of profits. The strength in the bottom line came from a reduction in loan-loss provisions and strong performance in what is considered to be the volatile fixed-income trading group.

A look at S&P 500 earnings estimates for 2011 would also lead one to believe that investor expectations are too high. Even with near-record profit margins, analysts are expecting earnings-per-share growth of 14% in 2011 on sales growth of 8.85%. To meet those lofty expectations, profit margins would have to rise to 9.4% in 2011. For 2012, analysts are assuming a further expansion in profit margins to 10.1%. Since 1993, the only year that S&P 500 profit margins exceeded 9% was 2006—the height of the real-estate bubble.

It is of course possible that S&P 500 profit margins will meet Wall Street estimates, but the odds are not in favor of such an event. Raw materials prices are surging, and employment growth is accelerating. Company costs are unquestionably rising and likely to rise further as the year progresses. That should put pressure on margins. When Google reported earnings this week, it said revenues rose 27%, but earnings advanced by only 18% because salaries and marketing and research expenses jumped 54%. In other words, Google’s profit margin fell. But if the bull case for earnings is right, Google will have to be an outlier this earnings season. If the company’s results are more indicative of a broadening trend, get ready for some stock-market volatility, because a profit slowdown isn’t priced into stocks.

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Jeremy Jones, CFA
Jeremy Jones, CFA, CFP® is the Director of Research at Young Research & Publishing Inc., and the Chief Investment Officer at Richard C. Young & Co., Ltd. Richard C. Young & Co., Ltd. was ranked #10 in CNBC's 2019 Financial Advisor Top 100. Jeremy is also a contributing editor of youngresearch.com.
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