Great expectations

First-quarter earnings season is upon us and profit numbers are under the microscope. Alisa Roth investigates where expectations come from and what they mean for investors.

Tess Vigeland: So last month JPMorgan announced a 50 percent plunge in first quarter profits and the stock price jumped. Huh?

And it seems like every time Apple announces a nice bump in earnings, the market groans over another "e" word: expectations. Companies fall below what analysts said they would.

What is it with these expectations? What are they? Who decides them? Should it matter to investors?

As the first-quarter earnings season winds down, we asked Alisa Roth to find out.

[Clips of analysts' expectations]: The earnings results for a company whose products range from lightbulbs to TV programs matched Wall Street expectations...

More than double the 1.3 million barrel decline analysts expected...

Google, too, handily beat the street's expectations with their earnings results...

The bigger story Tuesday was earnings: Coca-Cola and Johnson & Johnson, which topped Wall Street expectations...

Target, one of my favorites, beating analysts' first quarter expectations...

Alisa Roth: So do analysts just make these predictions up?

Rick Mendenhall: Different analysts do things differently.

That's Rick Mendenhall. A finance professor at University of Notre Dame.

Mendenhall: Mostly, they are doing what we call pro forma financial statements and so they are starting with the sales or revenue prediction and they're just building an income statement from there and they come up with a forecast for earnings.

A quick translation: he says analysts are guessing what the company's going to say about how much it earned. He says the market uses those predictions to gauge how much a stock is worth:

Mendenhall: If, on average, we expect to see a dollar of earnings and say we see 80 cents, then yeah, the price of that stock is going to go down.

Even if a year ago, the stock was only worth 50 cents. If we -- or the analysts -- think the stock should be worth more, we're disappointed when it's not. Companies try to get around this by managing analysts expectations.

It's a little like when your kid brings home a C in chemistry. If he's already warned you he might fail, you'll be pleasantly surprised by the C. Expect an A though, and the C is a big a disappointment.

Analysts don't always get it right, but when it comes to predicting future earnings for a company, Mendenhall says investors are better of listening to an analyst than, say, looking at a stock's past performance.

Mendenhall: Unless you're willing to do your own scrutinize the company, look at their product line, look at their competitors, estimate what sales revenue will be, then estimate all the costs on the income statement down to earnings. Unless you're willing to do that, I think analysts are the only game in town.

But he says most individual investors should just keep their heads down and concentrate on developing balanced, diversified portfolios.

These days, a lot of individual investors rely on vehicles such as mutual funds. In that case, Mendenhall has another suggestion:

Mendenhall: I think most of us would do well to ignore the analysts.

Better to keep an eye on the fund manager to see how she's performing. Companies like Morningstar rate fund managers so you can see if yours has been doing a good job.

But if you decide to listen to the analysts and if you're investing in individual stocks, you'd better. It's worth making sure there's no conflict of interest.

Beverly Walther is an accounting professor at the Kellogg School of Management. She says there are several things investors should ask:

Beverly Walther: Do they do investment banking business or not? Moreover, do they do investment banking business for the firm that the analyst is issuing a forecast on?

Walther also suggests reading analysts' disclosures -- do they have the company's stock in their own portfolio? -- and check analyst ratings in sources like the Wall Street Journal to see how accurate they've been in the past.