Understanding Stocks

100 UNDERSTANDING STOCKS
seasonal, quarter-to-quarter comparisons may not be as useful as year-toyear
comparisons.)
Unfortunately, finding out how much a company really earns is not
as easy as it appears. Some CEOs will play a number of accounting tricks
to make it appear that earnings are stronger than they really are. (To keep
stock prices artificially high, some CEOs “cooked the books,” or
changed the numbers so it appeared that the company was making more
money than it had in the past. In such cases, when the truth comes out, the
company is often forced to restate its earnings, causing the stock to plummet.
For example, WorldCom restated its earnings by billions of dollars.)
It’s not enough to buy stocks in companies that grow by more than
15 percent a year—you must also understand how the company makes
that money. It sometimes takes a stock detective to find out the truth.
The Earnings Estimates Game
Adding to the confusion about EPS, stock analysts (people who are
paid to independently research corporations and make buy or sell recommendations
on their stocks) make estimates or predictions of companies’
future earnings. Often, a stock will rise on the expectation that
the company’s earnings will grow in the future. If a company beats analysts’
estimates, the stock price usually goes up. If a company misses
analysts’ estimates, even by as little as a penny, the stock price usually
falls. Sometimes a company will beat analysts’ published estimates but
not beat the “whisper number,” an unofficial earnings estimate that is
generally not made public. As noted earlier, CEOs are under extreme
pressure to beat the earnings estimates.
Looking at Stock Ratios
The Price/Earnings Ratio: The Granddaddy of Stock Ratios
Many people use the price/earnings ratio (P/E) to get a quick indication
of whether the stock price is reasonable given the company’s earn-