One lesson many investors quickly learn is that the market is forward-looking. Security prices are dictated by expectations, and prices fluctuate as these expectations are affirmed or are proven to be unfounded. Some of the most frequently followed measures of market expectations are consensus earnings estimates. Stock Investor Pro provides a variety of earnings estimate data from I/B/E/S, which is part of Thomson Reuters, for about 40% of the companies in the database.
Here is the Estimates tab for Johnson & Johnson (JNJ):
We see that the company's consensus earnings per share estimate for the current fiscal quarter ending March 2009 is $1.218. For the current fiscal year ending December 2009, analysts are expecting Johnson & Johnson to earn $4.49 per share. When available, Stock Investor provides two quarters and three fiscal years of consensus earnings estimate data.
In addition, the current consensus estimated growth rate in earnings per share for the next three to five years is 7.943% on an annualized basis.
Examining the range of estimates, as indicated by the high and low estimates for each period (High. Est./Low Est.), provides an indication of the degree of consensus between analysts. A wide range of estimates would point to disagreement among analysts, indicating greater uncertainty, and a greater chance for an earnings surprise--the actual announced earnings are above or below the consensus estimate for the period. For the current fiscal year, analysts tracking Johnson & Johnson see earnings per share coming in at between $4.39 and $4.60.
Perhaps a more meaningful measure of uncertainty among analysts is the standard deviation of estimates. Standard deviation provides a statistical measure of the dispersion of the earnings estimates. Assuming that earnings estimates are normally distributed, there is a 68.3% probability that the actual earnings will be within plus or minus one standard deviation of the consensus estimate. Continuing with this assumption, there is a 95.4% probability that the actual earnings will be within plus or minus two standard deviations, and a 99.7% probability that the actual earnings will be within plus or minus three standard deviations. Therefore, given Johnson & Johnson's mean or average earnings estimate for the current fiscal year of $4.49 per share and a standard deviation of $0.052, there is a 99.7% probability that the company will announce fiscal year 2009 earnings per share between $4.334 and $4.646 (the mean estimate of $4.49 plus or minus three times the standard deviation of $0.02 or $0.156).
The number of estimates provides a feel for the depth of coverage for a company. Thirteen analysts currently provide estimates for Johnson & Johnson's current fiscal quarter ending March 2009.
Earnings surprises occur whenever a company reports actual earnings that differ from the consensus estimate. During the earnings reporting season—which for most companies follows the end of their fiscal quarters in March, June, September and December—financial newspapers and Web sites provide daily reports on earnings announcements. Firms with significant earnings surprises are often highlighted.
A positive earnings surprise occurs when actual announced earnings are above the consensus per-share estimate. Negative earnings surprises take place when announced earnings are below the earnings expectations. Firms with significant positive earnings surprises tend to show above-average price performance, while those with negative surprises tend to have below-average price performance.
When available, Stock Investor provides data for a company's last two quarterly earnings announcements.
To say that a company missed or exceeded their consensus estimate for the quarter does not necessarily capture the true significance of such an event. There are several ways of measuring the significance of an earnings surprise.
Returning to the figure above for Johnson & Johnson, we see that the company announced actual earnings per share of $0.94 on January 20, 2009 for the quarter ending December 31, 2008. This exceeded the consensus estimate for the period of $0.921 by $0.019 per share for a 2.1% positive earnings surprise. To calculate the percentage surprise, use the following formula:
Surprise % = (Actual EPS – EPS Estimate) ÷ EPS Estimate Johnson & Johnson Surprise % = ($0.94 – $0.921) ÷ $0.921 Johnson & Johnson Surprise % = 0.0206 or 2.1%
Another method of measuring the magnitude or significance of earnings surprises is with the standardized unexpected earnings (SUE) score. SUE measures the earnings surprise in terms of its number of standard deviations above or below the consensus earnings estimate. An earnings surprise is considered more significant the farther it is outside the statistical range of estimates expected at the time of the announcement. As stated earlier, assuming a normal distribution of earnings estimates, 68.3% of actual earnings will be within one standard deviation of the consensus estimate, 95.4% will be within two standard deviations, and 99.7% will be within three standard deviations. The absolute value of SUE measures the degree of unexpected earnings. When the announced or actual earnings equals the consensus estimate for the period, both the percentage surprise and SUE scores are zero.
The standard deviation of Johnson & Johnson's earnings estimates for the quarter ending December 31, 2008, was $0.02. Given this, along with the company's $0.019 per share earnings surprise, we arrive at a SUE score of 1.0:
SUE = (Actual EPS – EPS Estimate) ÷ Standard Deviation of Earnings Estimates Johnson & Johnson SUE = ($0.94 – $0.921) ÷ $0.02 Johnson & Johnson SUE = 1.0
Note that SUE scores in Stock Investor are absolute values, meaning they will never be negative.
As a general rule, those stocks with higher SUE scores tend to exhibit stronger price reactions to earnings surprises than stocks with relatively low SUE scores. However, this is not always the case.
Changes in stock price resulting from a positive or negative earnings surprise can be felt immediately, but the surprise can also have a long-term effect. While it may be difficult for individuals to buy on the initial surprise event, studies indicate that the effect can persist for as long as a year after the announcement.
Therefore, it may not be prudent to buy a stock that has declined following a negative earnings surprise thinking it is now "attractively priced." There is a good chance that the stock will continue to underperform the market for some time. Alternatively, it may not be too late to buy a stock that has seen its price jump following a positive earnings surprise.
Not surprisingly, the stock prices of larger firms tend to adjust to surprises faster than those of small firms. This is because more analysts and portfolio managers, who can buy and sell on news quickly, track larger firms.
Firms with an earnings surprise one quarter—either positive or negative—tend to have additional surprises in subsequent quarters. This so-called "cockroach effect" implies that where there is one earnings surprise, more are likely to follow. When a surprise signals a change in company fundamentals, management and analysts alike are typically slow to realize the strength and persistence of the change. As a result, company guidance and analyst estimates do not accurately reflect this change in fundamentals.
Beyond providing two quarter's and three fiscal year's worth of consensus estimate data, Stock Investor also allows you to follow the trend in the consensus estimate for each of these periods.
Looking at the trend in the consensus earnings estimate for Johnson & Johnson's current fiscal quarter, we see that the estimate was $1.232 per share three months ago. The consensus estimate has been in decline since, from the estimate of $1.228 one month ago to the current consensus estimate of $1.218.
If you see that the trend in consensus estimates is changing over time--either increasing or declining--it more than likely means that analysts are revising their estimates to reflect changes in expectations of future performance. Revisions are often precursors to earnings surprises, and a flurry of revisions near the reporting period may indicate that analysts have missed the mark and are scrambling to correct their estimates. It is also common to see earnings revisions when companies provide or update quarterly guidance.
Revisions to earnings estimates, no matter the reason, tend to lead to price adjustments similar to earnings surprises. When earnings estimates are revised "significantly," upward 5% or more, stocks tend to show above-average price performance. Likewise, stock prices of firms with significant downward revisions tend to show below-average price performance following the revisions.
Referring to the above of the Estimates tab for Johnson & Johnson, you will find the number of upward and downward revisions analysts have made to their earnings estimates over the last month. As of April 4, 2009, the consensus earnings estimate for Johnson & Johnson for the quarter ending March 2009 was $1.218. Over the four weeks prior, analysts had made two upward revisions to their estimates for the period and four downward revisions. The net effect was that the consensus estimate fell from $1.228 per share to $1.218 or $0.01 per share, a decline of 0.81%.
Back to Stock Notebook