So, a company’s earnings exceeded expectations for the quarter. Now what?
On one hand, this sounds like spectacular news. They beat the earnings goal … the stock price is bound to soar sky-high, right?
Not so fast.
Earnings expectations and stock performance are a little more complicated than that. To truly understand the impact of a company exceeding earnings expectations, it’s important to understand how earnings estimates work, who determines the estimates, and to consider the big picture of a company’s finances.
Ready to better understand how a stock’s performance can be affected by higher-than-expected earnings? Keep reading. This post is your jump-start lesson on the many factors that can sway earnings expectations.
Earnings Exceed Expectations?
First things first: What are earnings expectations?
Also referred to as earnings estimates, these are assessments of a company’s potential future EPS (earnings per share). The assessment is based on things like cash-flow analysis. It helps in estimates of target prices for shares.
These estimates are typically calculated on a quarterly and annual basis.
Who Sets Earnings Estimates?
Financial analysts determine earnings estimates. These are experts who use a variety of data, including guidance from the companies, forecasting models, and fundamental data to arrive at an EPS estimate.
The Consensus Earnings Per Share
The anticipated EPS isn’t derived from a single source.
Rather, the earnings estimate is the result of a consensus, an average based on the work of a variety of professional analysts. The consensus earnings per share can better capture the average and more likely to form a strong benchmark as a basis for the earnings estimate.
Why Earnings Expectations Matter for Investors?
Simply put, earnings expectations matter because how the actual stock performance stacks up to the estimate can move a stock. Higher earnings can push the stock price higher, and lower earnings can drive the stock price down.
Overall, earnings are also significant in considering a company’s long-term success. The market always looks forward … So if a company’s on the mark by meeting or exceeding expectations, it can help build trust among investors.
What Happens to a Stock if a Company Beats Expectations?
If a stock overperforms, it’s called an “upside surprise.” The stock price can see a big swing if the company sails past analyst estimates and makes a lot more money.
On the flip side, if a stock underperforms, it’s called a “negative surprise.” Often, if a stock doesn’t meet the estimates, it’s pummeled in the market, with share prices drastically dropping.
That’s the super simple answer: it doesn’t always play out quite like that. Let’s explore …
How Do Companies Beat Expectations?
The simple answer is that companies beat expectations if they make more money than expected. Maybe there’s a big contract or a surge in sales due to a new product or service. It could be for a number of reasons.
However, companies are adept at managing their earnings, too. Sometimes, they try to outfox the market.
How? They set low expectations via forward guidance that can make the consensus estimates lean low. That can allow them to regularly beat the estimates, making an earnings “surprise” less of an actual surprise.
Why Beating Earnings Expectations Doesn’t Always Move the Stock Price
Here’s where it can get tricky …
Let’s say that you make a big trade on a company with earnings that exceeded estimates. You start mentally counting your money in anticipation. But in the coming days and weeks, the stock price doesn’t go up — in fact, it drops. What happened?
This is an example of why fundamental research is so important for traders. Just because a company earned more doesn’t mean that the company is making great profits. For example, if they had much higher spending than usual, this could undercut those initially ‘impressive’ earnings.
You also need to consider the phenomenon of public sentiment too. Sure, the company beats analyst estimates. But maybe buyers had incredibly high hopes for the stock. If the company’s earnings don’t live up to the hype, the shares can slump.
What Are Earnings Revisions?
An earnings revision is when analysts alter their initial expectations. This might be due to a variety of reasons — a hot new product, a change in the sector, a change in economic outlook, and so on.
How Earnings Revisions Can Impact Stock Price
When analysts adjust earnings revisions upward, it can make the stock price rise. And the share price can drop when revisions are downward.
Frequently, revisions can be a harbinger of an earnings surprise. That’s to say: A flurry of activity near the company’s earnings release can alert potential buyers to an earnings surprise.
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I’m Paul Scolardi, and my trading career is based on locating momentum stocks before they peak, and taking advantage of them as a swing trader by buying low and selling high.
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If you’re curious about my methods and ready to try swing trading, consider joining my SwingTrades program.
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It’s important to remember that learning how to trade requires time, dedication, and lots of hard work. There’s an inherent risk to stock market investing, and it’s possible to lose your investment. So remember that any investing is at your own risk.
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Do you execute trades based on a company’s earnings estimates? How does it work out? Leave a comment and let me know!