Slate. All you wanted to know about earnings downgrades

Along with the anxiety about a Chinese slowdown and a foreign investor exodus, there’s one more factor that’s spooking Indian stock markets — the fear of earnings downgrades. For the last three years, analysts have been putting up rosy profit growth estimates for the BSE Sensex companies at 15-20 per cent for the year, only to find that these growth rates have been missed by a mile by year-end. FY16 is no exception, with weak demand, tumbling commodity prices and high interest costs triggering a spate of earnings downgrades.

An earnings downgrade happens when analysts tracking a company reduce their estimates of its profit growth for future years, based on a specific trigger. Tata Steel has seen its earnings for 2016-17 slashed by 7-8 per cent in the last couple of months, as a glut in the global steel market has pressured steel prices and looks to reduce the company’s realisations. Kotak Mahindra Bank has seen a few earnings downgrades for the current as well as next year, on worries that a lower contribution from capital market-related businesses could slowdown profit growth, even as the bank enjoys healthy trends in both loans and costs.

An earnings downgrade by an analyst is usually a precursor to a stock price fall. This is because every publicly traded stock is valued at a certain multiple, based on the growth rates expected for its profits in the next few years. If the cut in the earnings estimate is sharp, it can make the stock’s valuation appear expensive all at once, forcing analysts to changing their recommendation from a ‘buy’ to a ‘sell.’ Earnings downgrades often help explain seemingly irrational price behaviour of some stocks after their results.

Consider InterGlobe Aviation (owner of IndiGo airlines) which declared good quarterly results this week, but still saw its stock prices take a beating. Brokerages have scaled down their earnings estimates for the airline for the next two years, due to delays in deliveries of new aircraft . Motilal Oswal has slashed its profit estimates for the airline by 18 per cent for 2016-17 and 2017-18 to account for the delays in the addition of the more efficient Airbus A320Neo planes to its fleet.

At a broader market level, the number of earnings downgrades to upgrades can be good indicator of market direction. If downgrades are outnumbering upgrades, you can be sure that the fundamentals of India Inc are not in great shape. Sensex company profits have been on a relentless downgrade cycle since FY12, with estimates for double-digit profit growth from Sensex firms consistently being missed. Analysts have been reacting by setting up lower targets for each year, while pushing back their ‘double-digit growth’ goalpost to the next year.

If a stock you own is seeing a series of downgrades, its time to be wary. Yes, analysts are not always ahead of the curve and may continue to downgrade their estimates after the worst is over for a sector or a stock. But even if you don’t want to get unduly influenced by downgrades, it would be worth your while to understand the reasons for it and take a call on whether to hold or sell the stock.

If you’re looking for the Sensex to bottom out, pray for the downgrades to stop and the upgrades to resume.

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