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 Harvard Business School, 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.
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 ( GE – news – people ), Microsoft ( MSFT – news – people ) 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.
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.