Earnings estimate revision and earnings surprise

It doesn’t matter how big the company is—be it ExxonMobil or Mr.
Hooper’s corner grocery store—or whether it is public. The only
thing that ultimately determines how much a company is worth is
what it earns for its shareholders.


The reason earnings per share (EPS) are so important for publicly traded
companies is because earnings serve as a proxy for what a stock can
potentially deliver each quarter as a cash dividend payment—a divi-
dend that can be given to you explicitly in the form of cash, or implic-
itly in the form of capital appreciation when you sell your shares to
another investor for more than what you paid for them.

What analysts expect a company to earn in the coming quarter or
year is likely already reflected in a company’s stock price. What is
important is not how much analysts expect a company to earn, but
rather how these expectations have recently changed.

This is where changes to the consensus earnings estimate come in.
The cause and effect is clear: Upward revisions in earnings estimates
almost always cause a stock to climb; downward revisions in earnings
estimates almost always cause a stock to fall.

There is a delay in the market’s reaction to revisions to analysts’
earnings estimates. Because of their size and the way they select
stocks, it takes most institutional investors a bit of time to respond
to the earnings estimate revisions

instead of selecting from all
the stocks covered by analysts, we chose only from those stocks that
received upward earnings estimate revisions during the previous month,
we find something very interesting: Analysts are far more likely to revise
earnings estimates in the same direction as they did in the previous month.

If analysts raised their earnings estimates on a stock over the last
month, there is a good chance that they are going to revise earn-
ings estimates up in the next month.

This tendency for analysts’ earnings estimates in aggregate to be
revised in the same direction month after month is called analyst creep.

n fact, a stock that received an upward earnings estimate revision
last month has a 33% chance of receiving additional upward earnings
estimate revisions this month.

Analysts tend to “herd” with other analysts when making changes
to their earnings estimates. The analyst does this in order to pro-
tect his job. As a result, revisions to analysts’ earnings estimates
tend to be serially correlated over tim

Stocks that have been receiving upward earnings estimate revi-
sions in the past tend to outperform the market over the next one
to three months, while stocks that have been receiving downward
earnings estimate revisions in the past tend to under-perform the
market over the next one to three months.


What is important in evaluating the earnings of a company is
not what the company has earned historically, but rather, what
the company will earn in the future.This is why analysts’
earnings expectations are so important.


Our analysis indicates that changes in the current fiscal year consensus esti-
mate have the greatest value.

Quarterly earnings estimates are important, but it is not unheard of
for analysts to lower earnings estimates for the coming quarter while
raising earnings estimates for the year, due to cyclical seasonal factors

or a one-time weak quarter that is unlikely to repeat.

A good rule of thumb is to only buy a company that is expected to
turn a profit.Very simply, do not buy a stock unless analysts project that
the company will generate positive earnings per share in the current
and next fiscal year. Do not worry about five years from now, do not
believe stories of incredible earnings three years out, do not even wait a
year and a half for positive earnings.A bird in the hand is worth two in
the bush—make sure the consensus earnings estimate for the coming
and next fiscal year is positive.

Before buying the stock and committing hundreds if not thousands
of dollars to a position, you should obtain a couple of the analysts’
recent research reports and make sure that earnings estimates
were revised upward because business prospects and top-line
revenue are improving. Avoid stocks that analysts raised earnings
estimates on simply for accounting reasons.


Five Games Companies Play with Their Earnings

Game One: Firms Guide Analysts’ Earnings Estimates Low in
Order to Beat Expectations

Game Two: Firms Make Extensive Use of Legal Book-Cooking
through Non-recurring Charges

Game Three: Firms Make Use of Cookie-Jar Accounting

Game Four: Firms Engage in Timing Games with Earnings

Game Five: Firms Beat Expectations through Serial Acquisitions



Generally, you want to ask the following questions of the earnings
press release in order to determine the extent of the earnings surprise:
1. Were the reported earnings better than the quarterly consensus
earnings estimate?
2. Were the reported earnings better than the most recent analyst
earnings estimates ?
3. Were there extraordinary items that helped boost earnings?
4. Did the company warn for future quarters?
5. Did the company warn prior to announcing earnings?
6. Was the earnings surprise expected by the market?


There is a limited amount of earnings growth that can be
squeezed out of a company from controlling costs, and most of
this has already been fully accomplished by large-cap compa-
nies. That’s why, in looking at the quality of earnings, it is best to
focus on the firm’s revenues.

Post-Earnings Announcement Drift. Companies that report positive
earnings surprises tend to outperform the market over the next
three months

Companies that have historically reported positive earnings
surprises are more likely to report positive earnings surprises in the
future.This phenomenon is colorfully called the “Cockroach Effect.”

Earnings surprises are a lot like cockroaches. When you find one,
more are sure to follow. For this reason, a company that has histor-
ically reported earnings surprises in the past has a greater chance
of reporting earnings surprises in the future.

• When playing the post-earnings announcement drift, you
should give preference to companies that, in addition to
reporting a positive earnings surprise, also reported a positive
Sales Surprise.
• You should avoid companies that reported a positive earnings
surprise due to non-recurring expenses.
• You should also avoid companies that lowered earnings guidance
prior to or concurrent with a good earnings report.












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