As investors we hear it all the time. The analyst comes on CNBC and tells us a stock is soaring because the company beat earnings estimates. Or, we notice a stock is falling sharply and when we search the news we discover that the company missed analysts’ expectations.
These are common explanations for a stock’s market action. But, what do those words really mean? In other words, what are estimates, where do they come from, how often do companies meet the estimates and how do stocks fare, on average after an earnings announcement?
We will answer each of these questions today.
What Are Earnings Estimates and Where Do They Come From?
When the news refers to earnings estimates, the reference is generally to the average estimate of all analysts following a stock. The average of estimates can also be called the Wall Street consensus forecast or a similar term. But, the reference to expectations is almost always to an average.
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There can be dozens of analysts following a stock and publishing estimates. In general, the average of these forecasts is expected to be closer to the actual number in the long run. That’s why the estimates are averaged.
An average incorporates bearish and bullish opinions and minimizes the biases of any one analyst. Each individual forecast is derived from a model the analyst maintains. A popular framework for developing estimates is a discounted cash flow (DCF) model.
A DCF model requires dozens of assumptions and small variations in the assumptions will result in slightly different outputs. This explains why there can be such divergent opinions about a company.
For example, one analyst may estimate a 2% increase in sales and a 1% increase in costs. Another analyst may believe sales will rise by 2% bust costs will grow by 1.8%. The result will be two different earnings estimates that can vary by several cents or more.
How Accurate Are Estimates?
In general, no single estimate is likely to be very accurate. According to the research firm Factset:
“[Over a recent 15 year period], the average difference between the bottom-up EPS estimate one year prior to the end of that year and the final EPS number for that year has been +10.3%. In other words, analysts on average have overestimated the final EPS number by about 10% one year in advance.”
Factset also found analysts tended to be too optimistic most of the time:
“Analysts overestimated the final value (i.e. the final value finished below the estimate) in ten of the fifteen years and underestimated the final value (i.e. the final value finished above the estimate) in the other five years.”
This conclusion was confirmed in a wider study summarized by the Financial Post:
“Researchers at the University of Waterloo and Boston College said the credibility and usefulness of target prices has long been dubious, with media and investment managers frequently labeling target prices as merely sales hype.”
Based on their 2012 study of more than 11,000 analysts from 41 countries, the overall accuracy of target prices is not very high, averaging around 18% for a three-month horizon and 30% for a 12-month horizon.
The research also showed that the farther the target price is from the market price, the lower the accuracy and vice versa. The accuracy of a target price is strengthened, meanwhile, when it is revised to reinforce a buy or sell recommendation.
“We find that analyst target price revision is more reliable than target price level in predicting future returns,” the researchers said. “Unlike target price level, revision in target price is unlikely to be subject to conflicts of interest.”
Despite the fact that analysts are wrong most of the time, the consulting firm McKinsey found that tracking the trend in analysts’ estimates can be useful. Their research showed that companies where analysts are increasing estimates tend to outperform the stock market.
Companies where analysts are lowering estimates, as the chart above shows, tend to underperform the broad stock market trading. This could be useful when traders are researching stocks as potential buys. Requiring an upward trend in earnings estimates could improve an investor’s performance.
Likewise, avoiding stocks where analysts are lowering estimates could also boost performance. Investors could also use downward revisions in earnings as a signal to sell a stock they own.
How Much Do Earnings Announcements Move Stocks?
We know the estimates will be wrong most of the time, but we also know the earnings announcements can move stock prices. This is because the earnings announcement provides new information to analysts that will be fed into their models and they are likely to revise their future estimates.
In a typical quarter, we generally see 69% of companies beat expectations and we should expect many of those companies to see future estimates revised higher. That explains why the stock of a company that reports positive earnings surprises sees an average price increase of 1.2% between the time period that begins two days before the earnings release and ends two days after the earnings.
Missing expectations has a negative effect on a stock. The stock of a company that reports negative earnings surprises sees an average price decline of 2.4% between the time period that begins two days before the earnings release and ends two days after the earnings.
These are relatively large price moves. In a typical five day time period, we should expect a stock to move up or down by about 0.45%. The moves after earnings are released is 3 to 5 times as large as average.
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