Conventional earnings-based security analysis has lost much of its usefulness according to Feng Gu and Baruch Lev, who have published their findings on the topic in a recent issue of the Financial Analysts Journal. Feng Gu, professor of accounting at the School of Management, State University of New York, and Baruch Lev, professor of accounting and finance at the Stern School of Business, New York University, believe that over the past few decades, the usefulness of predicting corporate earnings, or consensus hits and misses—an activity at the core of most investment methodologies—has been shrinking fast. In this context, the usefulness of this tool is measured by the excess gains achieved by investors using such predictions in their investment process.

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Earnings-Based Security Analysis, No Longer Relevant? 

To arrive at the above conclusion, the researchers computed the gains from a three-month investment, starting 60 days before quarter-end and ending 30 days after quarter-end (to include the quarter’s earnings release) for companies that exactly met or beat analysts’ consensus earnings estimates and those that missed Wall Street consensus. The data showed that the returns available from correctly predicting a company earnings performance have fallen by 67% between 1989 and 2015. The average gains from investing in the companies that will meet or beat the consensus estimate continuously dropped from 6% in 1989– 1991 to 2% in 2013–2015. The gains from shorting the stocks of companies that missed the consensus are even lower at 1.6% in the most recent period. At one point, predicting consensus hits and beats was a winning strategy with annualized abnormal gains of 20% to 25%. However, it seems that today, according to the article, "earnings prediction has lost much of its relevance in recent years."

"GAAP-based reported earnings no longer reflect the periodic value changes (growth) of most business enterprises, and thus conventional earnings-based security analysis has lost much of its usefulness for investors in recent years."

With this being the case, instead of an earnings based investment strategy, the researchers suggest that today, "an effective investment analysis should thus shift the focus from earnings (operating consequences) to the value creators of the enterprise—its “strategic assets”—and their deployment in value creation." Strategic assets such as a biotech's drug pipeline or oil company's reserve base may be better indicators of value than vanilla earnings estimates.

"We assert that a shift of focus for security analysis and valuation is called for—from the prediction of earnings or related accounting measures to a comprehensive evaluation of an enterprise’s competitive advantage through a careful consideration of its operating strategic assets and their deployment."

An example given is that of subscription based media companies. Subscription revenue from these businesses is highly valuable and allows a company to monetize its competitive advantage, and deploy strategic assets.

See the full study here

earnings-based security analysis