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AAII How-To Earnings Investing Gurus

Consider Earnings Estimate Surprises and Revisions

Opportunity for an investor arises when reported earnings veer from expectations, or analysts revise their estimates. AAII provides the screens and data you need to identify stocks with earnings surprises or revisions.

by John Bajkowski | March 2020

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We are taught that the stock market is a very efficient pricing system. Stock prices generally reflect the market’s consensus of a full array of company, industry, regulatory and economic forces in play at any time. However, the market is also in a constant state of flux and may not always react rationally and instantly to new information. Benjamin Graham understood the challenge investors face and put forth that for an investor to beat the market they first must have a sound theory, then have opinions and projections that are not only correct but also different from those of the market.

Stock prices are established through expectations and adjust as those expectations change or are proven wrong. A slight change in projections can have a major impact on stock prices, especially if the multiple or price-earnings (P/E) ratio investors are willing to pay for a given level of earnings also expands or contracts. Stocks with high price-earnings ratios not only have high expectations, they also possess a higher anticipated certainty of realizing their growth. Lower multiples reflect lower perceived prospects as well as greater risk and uncertainty of achieving results.

Consensus estimates are the average of the estimated earnings and sales levels made by analysts who are following specific companies. Widely followed firms such as Amazon.com Inc. (AMZN) have over 40 analysts providing estimates, while smaller firms have just a few analysts following them. Over 460 companies have just one analyst projection. Just over 3,750 companies currently have earnings estimates from the universe of 4,641 exchange-listed companies tracked by I/B/E/S, a reporting service used by AAII.

When using earnings estimates, the first rule to consider is that the current price generally already reflects the consensus estimate. There is nothing to gain by simply looking for companies with high levels of expected earnings growth. Studies show that over the long run, stocks with high expected earnings growth tend to underperform stocks with lower growth projections. It is difficult to continually meet and exceed high expectations over an extended period of time—commonly referred to as reversion to the mean. The most profitable earnings estimate strategies focus on surprises and revisions.

Surprises

Stock prices of firms that significantly exceed analyst expectations (positive earnings surprise) tend to outperform the market, while those with negative surprises tend to underperform.

The impact of the earnings surprise is longer lasting than most would think. The greatest effect of the surprise can be seen immediately, but the impact of the surprise can be felt for as long as a year. The impact tends to be longer lasting for negative earnings surprises. It simply takes time for the market to recognize that a fundamental shift is taking place. This means that it does not generally make sense to be a bargain hunter and buy a stock after the initial price decline on a negative earnings surprise. There is a good chance that the stock will continue to underperform the market for some time. Separately, it may not be too late to buy into an attractive stock after a better-than-expected earnings report is released, provided the fundamentals are still valid.

Not surprisingly, large firms tend to adjust to surprises faster than small firms. Larger firms are followed by more investors, analysts and portfolio managers acting on the information more quickly and thoroughly.

Cockroach Effect

Firms with a significant quarterly earnings surprise also often have earnings surprises in subsequent quarters. This is sometimes referred to as the “cockroach effect”—like cockroaches, you rarely see just one earnings surprise.

Studies of earnings estimates by David Dreman found that stocks with lower valuations reacted more strongly to positive earnings surprises than did highly valued stocks. A positive earnings surprise for stocks with a high valuation (as measured by factors such as the price-earnings ratio) is not truly a surprise. It is a reinforcing event that does not change the perception about a company. However, positive earnings surprises for out-of-favor stocks are event triggers that initiate a perceptual change among investors. Dreman’s work notes that the opposite happens with negative surprises. Out-of-favor stocks often barely flinch, while highly favored stocks generally have significant declines after a negative surprise.

The chance of an earnings surprise is greater if the range of estimates for a company is wide; however, the price move can be more dramatic if an earnings surprise occurs for a firm with a very tight range of estimates and the actual earnings are well outside that consensus.

Revisions

Changes in estimates reflect changes in analyst expectations of future performance and lead to price adjustments similar to earnings surprises. When earnings estimates are revised significantly upward—by 5% or more—stocks tend to show above-average performance. Stock prices of firms with downward revisions show below-market performance.

Changes in analyst estimates are more meaningful when individual estimates move away from the average, rather than toward the consensus.

Screening for Revisions and Surprises

We have a number of screens incorporating estimate revisions and surprises that members can access online as part of their membership. You can access these screens in the Stocks area of AAII.com. Notable screens include:

Viewing a Firm’s Consensus Estimate

Members can see the latest earnings estimates for a given company and see if it has had any upward or downward earnings revisions. These estimates are provided on the snapshot tab of the stock quote page on AAII.com. The bottom of the snapshot page also indicates if the company currently passes any of the screens tracked by AAII (Figure 1).

Grading Revisions and Surprises

We have recently introduced Stock Grades for factors such as value, growth, momentum, quality and estimate revisions as part of our new A+ Investor service. The estimate revisions grade ranks companies by the strength of their recent quarterly earnings surprises and earnings revisions for the upcoming fiscal quarter and year (Figure 2).

Available to all AAII members, the Stocks page of AAII.com notes if any stocks have consistently high or low grades across the many factors and separately reveals significant changes in their grades (Figure 3).

Earnings estimates are an important element to consider as investors look for stock ideas and manage their holdings. ▪

Discussion

BARRY J from TX posted over 4 years ago:

This article it is very educational and relevant to today's environment where earnings are THE key differentiator going forward in markets under siege by the modern four horsemen of market apocalypse -- war, disease, volatility, and world tensions. Articles like this demonstrate the value of AAII membership. My contribution is that EPS is THE key indicator, not gross "earnings." Bare earnings must have a comparison to something to be meaningful – gross revenue, past performance, relative performance, and projected performance to organizations similarly placed in the same industry. As the article states, the EPS ratio uses "earnings" as the numerator (the variable of interest) and "number of shares outstanding" as the denominator (the base). One thing the article does not emphasize is that company management has considerable control over both these values. Management decisions impact both terms in the equation. They can manipulate "earnings" by choosing how they define "earnings" as long as they comply with FASB and GAAP standards. They can make adjusting entries to their general ledger that move accruals back or forward across accounting periods depending on how they "characterize" them. That is why some companies prefer to use EBITDA which provides management more control over more variables. In addition, management can manipulate the denominator -- shares outstanding - by repurchasing shares (to increase EPS) or issuing new shares (lowering share price to attract more investors). This reduces the size of the divisor which increases the impact of (unchanged) raw "earnings" in the numerator. these manipulations usually occur prior to EPS reporting to place some distance between act and impact. The magnitude of the impact can be offset by changes in share prices. Higher share prices may attract buyers. All these moving parts change relative to each other in the end. The same analysts who follow all these machinations supposedly use them in setting their earnings estimates. The key variable here is the number of analysts tracking the stock. They may not share their findings with non-subscribers. That’s where AAII and their I/B/E/S subscription come to our aid like the proverbial calvary (the good horsemen).


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