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, based on expectations for the company’s future. Over time, prices adjust as expectations change or are proven wrong. These changes in earnings expectations—no matter how slight—can have a significant impact on a stock’s price.

Both positive and negative revisions to analysts’ estimates of future earnings as well as earnings surprises—reported earnings above or below expectations—can have lingering long-term effects. Therefore, tracking the earnings revisions made by analysts can be a rewarding investment strategy.

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.

Tracking the earnings estimates made by analysts and the changes in those estimates is an important component of stock analysis.

The Impact of Earnings Surprises

There are several services that track and analyze earnings estimates. Services such as Refinitiv’s I/B/E/S, FactSet and Zacks Investment Research provide consensus earnings estimates by tracking the estimates of thousands of investment analysts. Tracking these expectations and their changes can help investors identify stocks likely to outperform or underperform in the future.

In using earnings estimates, the first rule to keep in mind is that the current price usually reflects the consensus earnings estimate. It is not unusual to see price declines for stocks that report earnings increases from the previous reporting period because, in many cases, while the actual earnings represent an increase, the increase is not as great as the market had expected. Earnings surprises occur when a company reports actual earnings that differ from consensus earnings estimates.

Most companies announce earnings during a window of approximately three to six weeks after the end of each quarter. During the earnings reporting season, business news channels and financial websites provide daily reports on earnings announcements. Firms with significant earnings surprises are often highlighted.

Positive earnings surprises occur when actual reported earnings are significantly above the forecasted earnings per share. Negative earnings surprises occur when reported earnings per share are significantly below the earnings expectations. The stock prices of firms with significant positive earnings surprises often show above-average performance, while those with negative surprises often incur below-average performance.

Changes in stock price resulting from an earnings surprise can be felt immediately, but surprises can have a long-term effect. This is because it is not unusual for analysts to underestimate (for positive surprises) or overestimate (for negative surprises) earnings for the future quarters in addition to the recently reported quarter. Studies indicate that the effect can persist for as long as a year after the announcement.

This means that it may not make sense to buy a stock after the initial price decline due to a negative earnings surprise. There is a reasonable expectation that the stock will continue to underperform the market for some time. The length of time an earnings surprise can have an effect on the stock also indicates that it may not be too late to buy into an attractive company after a better-than-expected earnings report is released.

Not surprisingly, large firms tend to adjust to surprises more quickly than small firms do. Larger firms are tracked by more analysts and portfolio managers who tend to act quickly. Firms with significant quarterly earnings surprises also often have earnings surprises in subsequent quarters due to analysts’ misjudgments. When a firm has a surprise, it often is a sign that other similar surprises will follow.

Since both positive and negative earnings surprises—and the revisions to earning estimates that follow—have lingering long-term effects, a rewarding investment strategy may be one that avoids stocks that have negative earnings estimate revisions or have reported lower-than-expected earnings. Selecting stocks with positive earnings estimate revisions and positive earnings surprises before and even after the earnings are announced may be profitable. Even a strategy of simply selling after negative earnings surprises and buying after positive earnings surprises probably has some merit.

Screening for Earnings Estimate 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 year are higher than they were one month ago and there have been no downward revisions of earnings estimates for the current fiscal year or for the next fiscal year over the past month.
• The downward revision screen seeks companies whose revisions are negative—the latest earnings per share estimates for the current fiscal year 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 for the next fiscal year over the past month.

Two additional screens require a minimum 5% estimate change for both the current and next fiscal year in order to see if significant upward or downward revisions have a greater impact on stocks.

These four screens are available to all AAII members through the Screening section of AAII.com. A+ Investor and Stock Investor Pro subscribers can customize the screens through the AAII Custom Stock Screener and Stock Investor Pro, respectively.

The specific screening criteria used for these analyst revision screens are included in this article.

Profile of Passing Companies

As shown in Table 1, the stocks with 5% or higher upward revisions have a lower median price-earnings ratio (16.6) than the typical exchange-listed stock (18.2), but the median price-to-book-value ratio (2.14) is higher than that for exchange-listed stocks (1.75). The median valuation ratios of stocks with 5% or higher upward revisions are overall very similar to that of exchange-listed stocks.

TABLE 1. Estimate Revisions Screens Portfolio Characteristics

Stocks with 5% or higher upward revisions have a significantly higher five-year earnings growth rate (24.9%) than exchange-listed stocks (11.9%) and the median for stocks passing the other three estimate revisions screens. However, their median future estimated earnings growth is more in line with the median for stocks from the other screens and the typical exchange-listed stock.

In addition, the stocks with 5% or higher upward earnings revisions have the highest median relative price strength over the last 52 weeks, outperforming the S&P 500 index by 35.5%.

This screen might be isolating stocks that have suffered financially in the past but are now showing signs of a turnaround, with rising earnings estimates that the market recognizes through price appreciation. Our screens select stocks with upward revisions after the revisions and subsequent price increase, and stocks with downward revisions after they have underperformed the market.

TABLE 2. 15 Stocks Passing the Estimate Revisions Up 5% Screen
(Ranked by Current-Year Revisions Made Last Month)

For a current list of stocks passing this screen, click here.

Given the nature of the screening criteria for these screens, it is not surprising to see that the stocks passing the two upward revision screens have positive median percentage increases in current fiscal-year earnings estimates over the last month, while the downward revision stocks have had large declines over the same period.

Among the stocks in Table 2 with the highest upward revisions, Independence Realty Trust Inc. (IRT), a residential real estate investment trust (REIT), had the largest percentage increase in current fiscal-year estimate over the past month at 155.5%. The consensus estimate increased from $0.25 to $0.64 per share. Additionally, the company had a 147.3% earnings surprise during its latest quarterly report in February 2022.

When looking at the stocks in Table 3 with the lowest revisions, Chewy Inc. (CHWY) had the largest percentage downward revision in its current fiscal-year estimate over the past month at –623.1%. Of the 25 analysts that cover Chewy, 16 had downward revisions. The consensus estimate went from –$0.06 to –$0.45 per share. The company’s fourth-quarter and full-year 2021 earnings missed analyst estimates significantly.

TABLE 3. 15 Stocks Passing the Estimate Revisions Down 5% Screen
(Ranked by Current-Year Revisions Made Last Month)

For a current list of stocks passing this screen, click here.

Conclusion

While the results of the upward earnings revision screens have shown promising results over the last several years, it is important to note that these screens are only first cut screens. They do not examine issues such as financial strength or liquidity. Instead, they highlight the importance of changes in expectations and their impact on stock prices, as well as the potential benefit of adding an earnings revision consideration to a more robust set of filters.

Furthermore, the companies passing these—or any other stock screens—do not represent a “recommended” or “buy” list of stocks. Stocks that pass a quantitative stock filter require further analysis by the investor. It is important to perform due diligence to verify the financial strength of the passing companies and to identify those stocks that match your investing constraints and requirements before committing your investment dollars. 

Related

AAII How-To

Consider Earnings Estimate Surprises and Revisions

Related

Feature

Downward Estimate Revisions Screen Tops Unconventional Year

Related

Investor Professor

Earnings Estimates