On a warm afternoon, two friends who were new investors turned on a business news channel during market hours and came across the experts expecting earnings downgrade on some stocks and indices.

Aditya: Hey Akhil! Did you check this? They are saying “Brokerages have slashed Nifty estimates by 3.5 per cent.” Also, they are saying that ABB, also a part of my portfolio, may face earnings downgrade. What’s happening? And what is earnings downgrade?

Akhil: Calm down, Aditya. Let me explain. Analysts downgrade earnings when the consensus estimates of a company’s profits for a few quarters reduce because of poor or below-par reported earnings. But when there is a consistent beat on profits, there would be a case for earnings upgrade.

Aditya: Okay, got your point. So, what are the reasons for such downgrades or upgrades?

Akhil: Let me explain with an example. JSW Steel faced downgrades from many brokerage houses after the company posted lower-than-expected Q4 FY22 profits on account of weak realisations and headwinds due to coking coal costs, which they expected to continue for some time.

Aditya: Understood. But are upgrades or downgrades only at a company level or do they happen at the sectoral level too?

Akhil: No, it is also applied for sectors and even broad market indices such as S&P BSE Sensex and Nifty 50. Analysts at brokerage houses take a holistic view on sectoral earnings and that of companies present in the indices. For instance, currently, IT sector as a whole is facing earnings downgrade due to elevated attrition numbers and increase in subcontractor costs and travelling costs; on the other hand, financial sector has seen an upgrade on account of strong loan growth led by revival in private sector capex.

How it works
At times, the downgrade can be for a short time while the stock might have good prospects in the long run

For a broad market index, one can check the EPS (earning per share) estimates given by brokerages which can be influenced by macro factors such as rise in interest rates by the RBI. For instance, you heard about Nifty estimates in the morning, right? So, Nifty EPS has been downgraded from ₹884-levels, quoted during June-end to ₹857-levels in the current scenario. Also, to get another perspective, one can look at the ratio of number of earnings downgrades to upgrades on a consensus basis.

Aditya: Okay. But how does all this help me as an investor?

Akhil: A sharp earnings downgrade or upgrade or a series of such steps may lead to a fall/rise in the price of the stock which you own. As ultimately, market participants use metrics such as price-to-earnings ratio and so if that stock is facing earnings downgrade, the stock might fall for that P/E number to sustain due to lower estimated earnings.

Aditya: Okay, so you mean that from now on I must sell the stock in case of earnings downgrade and buy when there is an upgrade?

Akhil: No that’s not what I meant. Analysts can’t always be accurate about their estimates. Also, at times, the downgrade can be for a short span of time while the stock might have good prospects in the long run. Ultimately, you need to check the reasons behind the downgrade or upgrade, whether the trigger is for long term or short term and make an investment decision while not getting completely influenced by analysts’ estimates.

Aditya: Thanks a lot, Akhil, for helping me understand this concept. From now, I’ll pay attention to earnings downgrades and upgrades.