April 16, 2013
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“There is no safety in numbers, or in anything else.”
Among the innumerable clichés littering the financial pages, few are as perversely ironic as the phrase “making the number.” Anyone unfamiliar with investing would almost automatically take this as an explicit warning: “Beware! These numbers are made.” And yet the same declaration is almost universally received by the investment community as reassurance. It’s a twisted, dangerous dynamic that only reinforces careless reliance on the most potentially manipulated of all available financial information.
Earnings are a metaphor, a misleadingly precise signifier of an amorphous, unknown economic reality.
Earnings results are only as relevant as their calculation is sound. This is why making investment decisions based on whether a company “makes” or “misses” its earnings estimate is like trying to understand a baseball game by watching the scoreboard instead of the field. Accounting, after all, is artifice – every financial statement is an act of principles-based interpretation, and GAAP leaves many gaps. Each line item is to some degree susceptible to interpretation, and therefore manipulation. Making the number is hence much less important than how the number is made.
By way of illustration, in late 2010 the shares of a number of large US banks leapt on the news that their quarterly earnings came in well above consensus expectations. This result was largely because they had reduced their estimates of future loan losses, and thus their reserves against them, thereby boosting their earnings by a corresponding amount. But how many individuals who bought the shares because they “beat their number” understood that math, or could explain why their prospective loan losses should be lower? Surely they weren’t simply accepting the company’s assessment; wildly inaccurate estimates of probable loan losses were what drove most of those institutions to the brink to begin with.
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