According to FactSet, at this point in the calendar fourth-quarter earnings season, more S&P 500 companies are beating their consensus estimates than average. Furthermore, these companies are generating larger positive earnings surprises than average.
Consensus estimates are the average of the analyst estimated earnings and sales levels made by analysts who are following specific companies. Widely followed firms such as Amazon.com Inc. (AMZN) have 40 or more analysts providing estimates, while smaller firms are lucky to have even one analyst following them. Of the nearly 4,000 companies that have at least one analyst providing an earnings estimate for the current fiscal quarter, roughly 500 have just one analyst estimate. Just over 3,950 companies currently have earnings estimates from the universe of 4,777 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—commonly referred to as reversion to the mean. The most profitable earnings estimate strategies focus on surprises and revisions.
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 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.
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—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.
A+ Investor subscribers have exclusive access to Stock Grades for over 6,000 stocks for factors of value, growth, momentum, quality and estimate revisions. The estimate revisions grade ranks companies by the statistical strength of their two latest recent quarterly earnings surprises and earnings revisions for the current fiscal year over the last month and three months.
Earnings estimates are an important element to consider as investors look for stock ideas and manage their holdings.
Using the A+ Stock Grades Screener, you can isolate those companies that grade highly based on earnings estimates (along with growth, value, momentum and quality).
Now that we are one month into the current earnings season, we can start to identify companies that have reported strong (or weak) earnings surprises as well as seeing their consensus estimates revised (upward or downward).
The A+ Stock Grades Screener allows you to filter for stocks with specific factor grades. As of the close on January 29, 2021, there were 241 stocks out of the universe of 6,114 companies with an estimate revisions grade of A.
This is still a large universe of companies to sift through, but applying filters for average value, growth and momentum (C or better) and above-average quality (B or better) narrows the number of companies down to 25:
This table is sorted in descending order by estimate revisions score.
To dig deeper into the Estimate Revisions Grade for an individual stock, we clicked on Abercrombie & Fitch Co. (ANF) from the table list to review to its Stock Evaluator page. From there, clicking on the Grades tab takes you to a detailed explanation of each of the five factor grades. For this example, we focus on Abercrombie’s Estimate Revisions Grade:
Abercrombie has an overall Estimate Revisions Grade of A. This grade is arrived at by using four different pieces of data:
To say that a company missed or exceeded its quarterly consensus estimate does not necessarily capture the real significance of such an event. There are several ways of measuring the significance of an earnings surprise. One 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. Assuming a normal distribution of earnings estimates, 68.2% 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. There is no earnings surprise when the SUE score equals zero; the actual earnings per share is in line with the consensus earnings estimate.
The standard deviation of Abercrombie’s estimates for its quarter ended November 24, 2020, was $0.191. Given this, along with the difference between Abercrombie’s reported earnings for the quarter of $0.76 per share and the consensus estimate of $0.00, we arrive at a highly statistically significant SUE score of 4.0 for the latest quarter. The SUE score for the quarter ending August 24 was even more statistically significant at 6.9.
The consensus earnings estimate for Abercrombie’s current fiscal year ending late-January/early February, stands at a loss of $1.059. One month ago, analysts were forecasting an annual loss of $1.341, and three months ago, the consensus loss for the year was $1.911. Using these numbers, we arrive at the percentage change over both the last month of 21.0% and the previous three months of 44.6%.
The “raw” values of the four metrics used for the Estimate Revisions Grade are then converted to percentile ranks, which compare them against all of the stocks in the universe. Abercrombie’s SUE score for the latest quarter of 4.0 ranks in the 81st percentile among the 6,100 or so stocks in the universe, while the 6.9 SUE score from the previous quarter ranks in the 93rd percentile. The percentage changes in the current year’s consensus estimate over the last month and three months rank in the 96th and 97th percentiles, respectively. The percentile ranks for the four underlying metrics are then averaged; for Abercrombie, that translates into an estimate revisions score of 91, which places it in the A or “very positive” range.
While investing in companies seeing significant upward earnings revisions has been shown to generate promising results over the long term, it is important to take into consideration elements of financial strength, quality or price momentum. As an A+ Investor, not only can you evaluate the estimate revisions of individual stocks, but you can also use the Stock Grades Screener to isolate those companies with high estimate revisions scores along with elements of growth, momentum, quality and value.
