How to Profit From Revisions in Analysts' Earnings Estimates
Earnings play a pivotal role in the long-term viability of a company, as well as its investment prospects. The market is forward-looking and stock prices are established, in part, on the basis of expectations for the company’s future. Over time, prices adjust as expectations change or are proven wrong.
In short, while companies are often rewarded for having strong historical growth, changes in earnings expectations, no matter how slight, can have a significant impact on a stock’s price.
What drives estimates?
Earnings per share (EPS) estimates involve the interaction of many company, industry, and economic forces. They embody an analyst’s opinion of such factors as sales growth, product demand, competitive industry environment, profit margins, and cost controls. Earnings are a key variable used to value stocks and, as a result, slight changes in expectations for future earnings or the earnings growth rate can translate into a significant and lasting impact on stock prices.
Services such as I/B/E/S, First Call, Reuters, and Zacks provide consensus earnings estimates by tracking the estimates of thousands of investment analysts (see Hot Links on page 18 for a listing of services tracking analyst estimates).
Tracking these expectations and their changes is an important component of stock analysis. In addition, tracking significant revisions can be turned into a rewarding investment strategy.
Screening for Revisions
A simple way to isolate companies whose consensus earnings estimate has been revised recently is through screening. AAII tracks a series of separate screens that look for companies with recent revisions. The screens are basic and simply focus on revisions to current and next fiscal-year estimates without any additional fundamental or price momentum-based considerations.
The AAII screens focus on two types of revisions:
- The upward revision screen seeks companies whose revisions are positive—the latest earnings per share estimates for the current fiscal years are greater than they were one month ago and there have been no downward revisions of earnings estimates for the current fiscal year as well as the next fiscal year over the last month.
- The downward revision screen seeks companies whose revisions are negative—the latest earnings per share estimates for the current fiscal years are lower than they were one month ago and there have been no upward revisions of earnings estimates for the current fiscal year as well as the next fiscal year over the last month.
Two additional screens require a minimum 5% estimate change for both the current and next fiscal year, to see if significant upward or downward revisions have a greater impact on stocks.
Stock Investor Pro, AAII’s fundamental stock screening and research database, includes these four screens for stocks with earnings estimate revisions.
The specific screening criteria used for these analyst revision screens are listed at the end of this article.
AAII tracks over 50 stock screening methodologies and reports the companies passing each of these screens on AAII.com each month. In addition, members can view the performance of simple hypothetical portfolios invested in the companies passing these screening methodologies that have been backtested over the last seven years. The four screens for upward and downward earnings estimate revisions are part of this analysis.
Figure 1 shows the performance for all four screens.