When the earnings beat or miss is significant, it will likely have an impact on the company’s stock price. This price movement can be temporary or it can be a continuation of a trend in place before the company reported earnings. In this article, we’ll take a closer look at earnings surprises, including some of the popular forecasting models that analysts use to estimate the value of a company.
Overview of Earnings Surprises
Earnings season is a time when a company’s stock price can make outsized movements and an earnings report is like a report card for investors. The Securities and Exchange Commission (SEC) requires every publicly traded company to deliver an earnings report to shareholders on a regular basis, usually quarterly.
This report covers a range of issues that affect business operations. In the financial press, it boils down to the company’s revenue (the top line) and earnings per share, or profit (the bottom line).
Analysts spend extensive time researching a company and cover this type of data. They speak with management, visit facilities and pay attention to macroeconomic conditions that could affect the sector in which that company operates. From there, the analysts post expectations for the company’s revenue and earnings per share for the upcoming period.
On many occasions, a company reports higher or lower earnings than what analysts expect. These are known as earnings surprises and they can occur on the upside (an earnings beat) or the downside (an earnings miss).
MarketBeat offers subscribers the MarketBeat earnings screener which could also be used as an earnings surprise screener. That’s because the screener allows you to search for a company’s earnings results based on specific criteria such as whether its earnings per share (EPS) estimate came in higher or lower than the consensus estimate of analysts.
The next section provides more details about different earnings surprises that investors can expect.
Breaking Down Earnings Surprises
In addition to providing the raw numbers, companies use their earnings reports as a way to provide guidance about upcoming quarters or the entire year. As a free service, you can find the latest earnings reports from MarketBeat by looking under the tab called “earnings calendar.”
Don’t forget to review the earnings transcript of the company’s conference call. What are earnings transcripts? They are audio recordings and/or written transcriptions of everything that a company says to analysts and investors after they report earnings.
Pay close attention to what company management says to understand how it may affect your investment decisions. MarketBeat has a tool that can help you read or listen to many transcripts. MarketBeat also provides tools to help you learn more about earnings guidance data.
There are four types of earnings surprises: a double beat, a double miss, a “beat on revenue but a miss on earnings” and a “miss on revenue but a beat on earnings.”
The Double Beat
The “double beat” is the most bullish of all outcomes. This means that for the quarter just ended, the company sold more than analysts expected. More importantly, it generated a higher profit. This could mean that its products had a higher profit margin or it could mean that the company has an efficient cost structure that allows more revenue to go to the bottom line.
In either case, it’s considered bullish for the stock, so you can weigh this against the company’s future guidance. A company may issue a warning that while it beats on revenue and earnings in the current quarter, that trend will not likely continue. In this case, the company’s stock could drop in value. However, if that forward guidance suggests that revenue and earnings will continue to grow, the stock could move much higher.
The Double Miss
Not surprisingly, the “double miss” is the most bearish of all outcomes. This means that the company generated less revenue and profit than the analysts expected. If this is followed by negative guidance, you may want to sell your stock. On the other hand, if the miss was caused by conditions largely outside of the company’s control, you may decide to hang on to the stock, particularly if the company pays a dividend.
For example, at the onset of the COVID-19 pandemic, many companies saw their stock prices plunge. In the initial quarters, many delivered lower revenue and earnings than forecasted. However, when companies quickly reversed, prudent investors made substantial gains.
Beat on Revenue, Miss on Earnings
A “beat on revenue, miss on earnings” is generally seen as bearish. When a company increases its sales but doesn’t generate as much profit as in prior quarters, it suggests some kind of negative pricing imbalance. In many cases, it signals that the company does not have the pricing power to pass along increasing producer costs to its customers. If the company operates in a highly cyclical sector, this may weigh on the stock for several quarters and may encourage you to sell your shares.
Beat on Earnings, Miss on Revenue
Conversely, a “beat on earnings, miss on revenue” is seen as neutral to slightly bullish. Obviously, it’s not great for a company to sell fewer products. If the numbers beat profit expectations, it can suggest that the company has a high profit margin and that its customers will pay that premium to own the products. If investors believe that the situation will continue for several quarters, it may be time to buy shares even though the stock may go higher after earnings.
Earnings Surprises and Analyst Estimates
Let’s take a look at what analysts typically recommend for individual stocks:
- “Strong buy” or “buy” recommendation: This means that the analyst has made a recommendation for investors to buy a particular stock or security. You can expect a company to beat analysts’ recommendations.
- “Strong sell” or “sell” recommendation: This means that an analyst has made a recommendation for investors to sell or liquidate their position in a particular stock or security. In this scenario, the revenue and profit estimates already price in this sentiment.
- “Neutral” or “hold” recommendations: This means analysts have not called for specific buy or sell action. Rather, they give their opinion on the performance of the stock. This rating is given when an analyst expects the stock to perform in a way consistent with the performance of the broader market, or with comparable companies within the analyst’s sector of expertise. This rating could cause the biggest upside or downside from earnings surprises.
In recent years, many analysts have started to add clarity to the expected movement of their stock forecasts using two additional categories:
- “Underperform” rating: This means the expectation for the stock will perform below the market or sector average. Analysts may use ratings such as "moderate sell,” “weak hold" or “underweight” in place of “underperform.”
- “Outperform” rating: This is the opposite of an “underperform” rating. Stocks that receive this rating should outperform the market or sector average. Analysts may also substitute words like “moderate buy,” “accumulate” or “overweight.”
Popular Forecasting Models Used
As we noted earlier, analysts take the information they receive from company executives as well as their own boots-on-the-ground research to determine a company’s valuation and to determine the economic value of a business.
If you have a background or interest in finance, you may want to look at a company’s balance sheet and do your own calculations. For example, a company’s price-to-earnings (P/E) ratio can be a clue as to whether you should buy a stock. What is price-to-earnings ratio, exactly? That’s when you can rely on the calculations provided by analysts. Here’s a look at some of the more popular valuation models.
Market Capitalization
You can calculate a company’s market capitalization (or market cap) by multiplying the company’s share price by the total number of shares outstanding.
For example, on November 7, 2022, The Coca-Cola Company (NYSE: KO) had a share price of $59.45 and 4,324,513,000 shares outstanding. The company’s market cap is determined by the formula 59.45 x 4,324,513,000 to arrive at the company’s market cap of just over $257 billion.
Times Revenue Method
This method assigns a multiplier to a company’s revenues generated over a period of time. The multiplier takes into account the company’s industry and current economic conditions. Tech companies typically have larger multiples than, say, utility companies.
Earnings Multiplier
This method is similar to the times revenue method but puts the multiplier on earnings instead of revenue. Earnings tend to be a more accurate indicator of a company’s future success than revenue. The earnings multiplier is assigned to a company’s future cash flow that could be invested at the current interest rate over a specified period of time (usually 12 months).
Discounted Cash Flow (DCF) Method
The discounted cash flow method, a commonly used model, looks similar to the earnings valuation model in that it seeks to project future cash flows to the current market value of the company. This model takes inflation into account.
Book Value
A company’s book value measures the value of the equity that shareholders have in a company. Book value, shown on a company’s balance sheet, subtracts a company’s total liabilities from its total assets.
How Much Weight Should Investors Give to Earnings Surprises?
The answer to this question depends on what you believe about the accuracy of the earnings estimates. First, consider the accuracy of the information offered by the company. It has become increasingly common for companies to deliver preemptive earnings announcements.
In the best-case scenario, you may consider it a step toward transparency. On the other hand, analysts can lower expectations that the company can then beat.
Another factor is analyst objectivity. Prior to the dot-com crash of 2000, brokerage houses and other firms received “soft money” as compensation which led analysts to provide research and issue better ratings than a company would have otherwise merited. One regulation that has emerged since the dot-com crash requires analysts to use commonly accepted valuation techniques in their analysis, such as the factors listed above. This ensures that the methodology they use to assign a value to the company follows generally accepted accounting principles (GAAP).
However, a more fundamental reason for analysts to be as accurate as possible is their own credibility and that of their firm. To that end, MarketBeat provides an analyst rankings tool that displays the average return on investment (ROI) for every analyst that made a “buy” or “strong buy” recommendation. Investors can sort results by country, sector and market cap.
Use Earnings Surprises to Your Advantage
An earnings surprise occurs when the revenue and/or profit that a company reports exceeds or falls short of analysts’ estimates. When this occurs, it usually has a proportionate effect on a company’s stock price. That means the larger the beat or miss, the higher or lower the stock price can move.
Analysts use the information they have gathered from closely following the companies to provide investors with accurate revenue and earnings estimates. For a variety of reasons, their numbers may understate or overstate a company’s actual results.
Use these estimates as a guide and prepare yourself to rethink your own ideas about the company if the earnings report delivers results that contradict your reasons for taking a long or short position in a stock.
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