Every 3 months, the financial media pounces on earnings speculation like lions on raw meat while earnings estimates set the benchmark for performance.
Conference call reports from big name firms like Amazon or Microsoft dominate the CNBC headlines and stocks are often more volatile when the reporting companies miss or beat the analysts’ estimates.
So why do earnings estimates matter?
Because a stock’s value depends more on future expectations than past performance. Earnings estimates are just that, estimates, but it’s one of the few ways investors can gauge a company’s future based on a consensus opinion from professionals.
And while the importance of earnings predictions can be debated, they’re often the catalyst for big moves, day traders need to pay attention so regardless of personal opinions.
Earnings season is the financial media’s Super Bowl and you’ll need to respond accordingly.
What Are Earnings?
Earnings projections are meant to guide expectations about the future prospects of publicly traded companies. Analysts attempt to project a company’s future profits over a number of different time frames, but the quarterly reports are the ones that draw most of the headlines.
Calculating earnings is rather simple – just divide a company’s net profits by the number of outstanding shares.
This number is presented as Earnings Per Share, or EPS. When analysts make their predictions, they’re predicting EPS for the next quarter, or year, or however long a time frame they choose.
For example, Amazon reported an EPS of $6.47 in the 4Q of 2019. With about 498M shares outstanding, it’s easy to calculate that Amazon’s net profits for the quarter were $3.26B. Analysts had predicted EPS of $4.07, or quarterly net profits of $2.3B.
The company reported these earnings during their after hours conference call on January 30 and the stock responded with a huge gain the following day.
What Are Earnings Estimates?
Analysts from all over the financial sphere give estimates on the earnings of publicly traded companies. Research firms like Credit Suisse, UBS, Barclays, and Nomura all employ analysts whose jobs are to cover specific equities and give quarterly earnings estimates.
Why quarterly? Because those are the rules!
According to federal regulations, companies traded on public markets must report their profits to shareholders each quarter. Conference calls and Q-and-A sessions aren’t just a courtesy to shareholders and financial news media – they’re required by law.
Since publicly traded companies must report their finances each quarter, analysts giving estimates on their earnings is the most common way to predict future performance. Earnings estimates by themselves aren’t particularly useful – each analyst has their own opinion on the company and will make projections accordingly.
But estimates are pooled together to form a consensus and that average consensus is used to set expectations.
For example, look at the analyst projections for Costco, a heavily-covered stock. Yahoo Finance took estimates from 25 different analysts for the company’s upcoming 2Q report. The average estimate was an EPS of 2.04, but the range floated between 1.7 and 2.34.
Analysts use different data points and factors to come up with their predictions, but equal weight is usually given when compiling the average. If Costco reports an EPS number of 1.78 during their 2Q conference call, it will be recorded as an ‘earnings miss since the consensus expectation was 2.04.
Why Do Analysts Give Earnings Estimates?
Why do analyst estimates matter?
Well, not everyone agrees that they do. It’s speculated that many companies game the system and intentionally create low expectations in order to surpass the published projections. MarketWatch noted a 2016 study from Bespoke Investment Group showed that beating analysts’ expectations is far from uncommon.
They calculated the rate of earnings beats in the broader market (cleverly called the ‘beat rate’) and showed that companies surpass the projections 61% of the time.
So why do analysts even bother to give estimates?
Because consensus earnings projections are still an important piece of the puzzle. Just because a company posts an EPS number of 6.47 doesn’t mean its stock will outperform a company with an EPS of 2.04.
Estimates matter for one reason – they forecast expectations.
Expected results compared with actual results is what moves stock prices, not so much the raw numbers themselves. By factoring in future guidance with current data, financial analysts can at least attempt to form accurate valuations of complex enterprises like publicly traded corporations.
How Do Earnings Estimates Affect Stock Prices?
Let’s invent two companies here – Alpha and Beta. Alpha is a giant conglomerate with multiple successful legacy products. Beta is a small cap company trying to break into the big leagues with a new, innovative product. Both companies operate in different sectors and neither considers the other a competitor.
For Alpha, the analysts predict an EPS range of 6.55 to 7.25. Beta only gets a range of 1.34 to 1.95. Both companies have conference calls on the same day: Alpha reports 6.25 EPS and Beta reports 1.99 EPS.
Even though Alpha made three times the net profits of Beta, Beta’s stock will respond better because they surpassed the consensus expectation. Sure, there might be an analyst or two who predicted Beta would have EPS numbers of 1.99 or 2.00, but the average is what matters.
On the other hand, despite taking in a much larger pile of profits, Alpha’s stock could be in trouble. Since the company failed to meet the consensus expectation, the stock will likely be punished.
Performance relative to expectation is the important metric, so a company with lesser profits can still see its stock soar past bigger rivals.
Like everything else with trading, there are no 100% fail-proof strategies.
A stock that beats earnings estimates isn’t guaranteed to rise and one that misses isn’t a sure thing to drop. Remember, stocks care more about the future than the present and a great earnings report could come along with grim future guidance from the CEO.
Many examples of this are occurring right now during the coronavirus pandemic – companies are beating expectations but not offering guidance, which limits the upside of the shares.
Playing earnings season is a popular day trading strategy, but like all techniques, utilizing earnings estimates should just be one tool in a diverse trading toolbox.
Not only is it difficult to predict the net profits a company will post each quarter, but you can’t assume the stock will move in your favor if you guess accurately. Earnings season definitely brings more volatility than usual, which attracts traders to the market and creates opportunities.
Just be sure to understand the limitations of the information earnings estimates offer.