When companies deliver their quarterly results, investors are watching - not just for improvements, but also for how these results compare to analysts' estimates. If the company surprises the market with better-than-expected earnings, the stock usually jumps. On the other hand, disappointing results can cause the stock to tumble. In this article, we'll show you how understanding surprises in earnings can help you as an investor cope with quarterly earnings seasons.

Earnings surprises occur when a company's results differ from so-called consensus estimates. How earnings results measure up to Wall Street analysts' estimates are important to the price of stocks. Keenly watched and widely disseminated, quarterly earnings announcements made by companies are key triggers for short-term stock price behavior.

Stocks of companies that surprise the market with better-than-expected quarterly numbers are swiftly ratcheted-up in value. By contrast, a negative earnings surprise will usually cause the stock to be sold off by the market, especially if there are high growth expectations factored into its share price and it is expensive relative to those expectations.

Even a strong set of quarterly results, if they fail to beat or exceed analysts' expectations, can send a stock tumbling. Consider Advanced Micro Devices. For the first quarter of 2006, the chip technology company saw a delivered earnings per share (EPS) profit of $0.38 - 50% higher than the first quarter in the previous year. Nonetheless, because the consensus EPS expectations for Advanced Micro Devices were pegged at the higher profit of $0.43, the stock plummeted by 9% when the earnings results were released. (To learn more, read Types Of EPS, Earnings Forecasts: A Primer and How To Evaluate The Quality Of EPS.)

How Earnings Surprises Occur
Earnings surprises can be seen as a measure of analyst error. While a few analysts tend to make remarkably accurate forecasts, others miss earnings by a mile. There are plenty of good reasons why analysts' estimates come in wide of the mark. These include:

1. Forecasting Is Difficult
For starters, forecasting is a tricky business. Companies are subject to hard-to-predict forces, and these can have a big impact on their financial performance. With only publicly-available information to rely on, it's awfully difficult for analysts to predict precisely how many products a company will sell and the cost of doing business in the future. Expecting analysts to hit the bulls-eye with their earnings estimates may be unrealistic.

2. Herd Behavior
Research shows that analysts tend to exhibit herding behavior, shifting their forecasts over time to be more in line with their peers. A study by Robert Olsen, titled "Implications Of Herding Behavior" (1996) in the Financial Analysts Journal, shows that analysts tend to prefer not to make earnings predictions that differ greatly from consensus estimates for fear that they will be proved wrong. Unfortunately, the herd is not always correct.

3. Confirmed Optimists
Over-optimism increases the chance of analyst error. The trouble is, analysts' earnings forecasts generally err on the high side rather than the low side. More often than not, analysts start the year estimating too high, and then spend the period revising their estimates downward.

Analysts prefer to remain positive on a stock for fear that if they get on a company's wrong side they will be cut off from management and information flows. Brokerage houses are inclined to be optimistic to encourage investor clients to buy into stocks. According to Mark Bradshaw of HarvardBusinessSchool, stock analysts are persistently optimistic in their forecasts of corporate clients that issue equity and debt.

4. Managing Expectations
Companies are getting better at avoiding negative earnings surprises. Company executives can influence analysts' expectations through pro-forma earnings forecasts or "guidance" information they provide at press conferences, conferences and other meetings they arrange. The goal is to manage analysts' expectations to ensure earnings results and, at the very least, meet consensus estimates. (For further reading, check out Understanding Pro-Forma Earnings.)

Increasingly, companies will report bad news well ahead of earnings announcements. Management will try to get any unpleasant news out in the open so that there are no nasty surprises at report time. In fact, many companies now try to talk down expectations just enough so that there will be positive earnings surprise when results are announced.

Talking down expectations is getting so prevalent, it's arguable that positive earnings are having less of an impact on share prices. Big public companies, such as General Electric, Microsoft and Walmart regularly beat analysts' consensus estimates. Beating estimates by a penny or two no longer surprises the market.

In a bid to manage earnings, companies have been known to reserve extra earnings in a good quarter to inflate earnings in a future bad quarter. Companies anxious to hit aggressive analyst expectations may try to inflate earnings through easing credit policies, or "stuffing" customers with more product than they need. Even worse, the need to meet or beat consensus estimates has prompted some companies to turn to illegal accounting practices. (For more insight, see Earnings Guidance: The Good, The Bad And Good Riddance and Getting The Real Earnings.)

Quarterly earnings surprises can impact share prices - certainly in the short-run. If you are interested in how a stock moves after its quarterly results, it's worth keeping track of surprises. But as an investor, you probably shouldn't put too much stock into surprises as indicators of a company's long-term investment prospects. In essence, surprises tell us about analysts' ability to predict earnings and company's ability to manage those predictions - neither of which says much about whether the company's stock is worth buying.

Related Articles
  1. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  2. Investing

    What a Family Tradition Taught Me About Investing

    We share some lessons from friends and family on saving money and planning for retirement.
  3. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  4. Stock Analysis

    The Biggest Risks of Investing in Pfizer Stock

    Learn the biggest potential risks that may affect the price of Pfizer's stock, complete with a fundamental analysis and review of other external factors.
  5. Professionals

    4 Must Watch Films and Documentaries for Accountants

    Learn how these must-watch movies for accountants teach about the importance of ethics in a world driven by greed and financial power.
  6. Active Trading

    An Introduction To Depreciation

    Companies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
  7. Markets

    PEG Ratio Nails Down Value Stocks

    Learn how this simple calculation can help you determine a stock's earnings potential.
  8. Investing

    What’s the Difference Between Duration & Maturity?

    We look at the meaning of two terms that often get confused, duration and maturity, to set the record straight.
  9. Fundamental Analysis

    Buy Penny Stocks Using the Wisdom of Peter Lynch

    Are penny stocks any better than playing penny slots in Vegas? What if you used the fundamental analysis principles of Peter Lynch to pick penny stocks?
  10. Fundamental Analysis

    Are Amazon Profits Here to Stay?

    Amazon is starting to look like a steadily profitable company. Is this really the case? Should investors even be hoping for profitability?
  1. Can working capital be depreciated?

    Working capital as current assets cannot be depreciated the way long-term, fixed assets are. In accounting, depreciation ... Read Full Answer >>
  2. Do working capital funds expire?

    While working capital funds do not expire, the working capital figure does change over time. This is because it is calculated ... Read Full Answer >>
  3. How much working capital does a small business need?

    The amount of working capital a small business needs to run smoothly depends largely on the type of business, its operating ... Read Full Answer >>
  4. What does high working capital say about a company's financial prospects?

    If a company has high working capital, it has more than enough liquid funds to meet its short-term obligations. Working capital, ... Read Full Answer >>
  5. How can working capital affect a company's finances?

    Working capital, or total current assets minus total current liabilities, can affect a company's longer-term investment effectiveness ... Read Full Answer >>
  6. What can working capital be used for?

    Working capital is used to cover all of a company's short-term expenses, including inventory, payments on short-term debt ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center