Has this ever happened to you? One of the stocks you own announces their earnings results for the latest quarter, and you are pleased to see that they actually did better than you expected. Then, to your great surprise and consternation, the price of your beloved holding goes down instead of up. Or how about one of your stocks going up after admitting to the world that they actually managed to lose money in the latest quarter? These kinds of odd, counter-intuitive price reactions to earnings announcements are common, and they are quite normal. Here’s why.
In the examples above, actual earnings did not turn out as the market had expected. And in the sometimes topsy-turvy world of investing, expectations play a key role in determining if a stock’s price rises or falls when actual earnings are reported. So who exactly is the market in this earnings expectations dance? It’s the consensus of all the analysts from all the major research firms who follow the company in question. The consensus of expert expectations can be very different from your own expectations, and thus the possibility for the price of the stock in question to go against logic and common sense.
Investors who have a moderate amount of experience eventually learn from observing this phenomenon. They figure out that the market is forward-looking. Security prices are driven both by earnings themselves, and by consensus earnings expectations Prices change as these expectations change or are proven to be off the mark. Over the last few years, we have seen a big increase in the number of research and reporting services that track and analyze expected earnings estimates.
Services such as Zacks, First Call, Standard & Poors, IBES, and others provide consensus earnings estimates by keeping track of the estimates of thousands of investment analysts at hundreds of investment firms. The key question is, how can a regular investor take advantage of this apparent disconnect between reality and expectations? There is no simple answer to this question, but an entire industry exists to support the notion that it can be done. All that’s required is that you pay someone who claims to be “in the know” about these things, and they will provide you with a list of upcoming earnings announcements, along with the corresponding consensus expectations, and a prediction (wild guess) about which companies will beat those expectations, and which will miss the mark.
Caution: Do not get bamboozled into paying someone for this kind of information, because it’s almost entirely guesswork. The average investor can find far better uses for his or her limited investment research budget than this. There’s a sucker born every minute. Don’t become one by believing that anyone can tell you ahead of time which companies will beat their expectations.