Earnings Surprises

By Victoria Owens
Analyst, mPower

In This Story What Is an Earnings Surprise? How Does the Market React? Negative Surprises Can Affect Whole Industries "Managing" Expectations Mutual Fund Managers Your Portfolio

After the close of each fiscal quarter, Wall Street analysts, money managers, and individual investors anxiously wait for corporate earnings announcements to reveal whether companies have lived up to market expectations.

The marketplace often rewards the stocks of companies that surpass earnings estimates for the quarter and punishes those that fall short.

minute: read this article at a glance.

Technical Terms Earnings Sector Volatility

Earnings woes have been an important contributor to the market's recent volatility. Over the past several months, many companies disappointed Wall Street and suffered major stock price setbacks as a result. Earnings are now under a glaring spotlight as many investors worry about further surprises and some hope that earnings rebounds will boost their languishing stocks.

What Is an Earnings Surprise?

Earnings per share is a measure of a company's profit over a certain time period divided by the average number of shares outstanding during that span. For example, Microsoft Corporation posted net income of $2.624 billion over the three-month stretch ended Dec. 31, 2000. This figure, divided by the 5.570 billion average diluted shares outstanding during that period, resulted in earnings per share of $0.47 for the quarter.

"The marketplace often rewards the stocks of companies that surpass earnings estimates for the quarter and punishes those that fall short." — Victoria Owens, analyst at mPower Advisors, LLC.

This number is a common measuring stick for companies' performance. Investors often strive to assess stock values based on companies' estimated earnings for the coming years.

Stock analysts, often termed "Wall Street analysts," are hired by investment firms to evaluate the financial strength of companies and make buy-and-sell recommendations for those companies' securities. One major task for analysts is to project, or estimate, businesses' earnings growth for the coming fiscal quarters or years. Depending on the company and industry under consideration, analysts formulate their earnings estimates based on a variety of factors, including historical operating results, guidance provided by executives, industry demand trends, the quality of a business' product or service offerings, cost-efficiency initiatives, and a company's overall financial health.

Analysts' estimates for the coming quarters are compiled by a variety of sources, including Zacks Broker Research Report Service and First Call. These services calculate the average of analysts' estimates, or their "consensus" — a key benchmark against which companies' actual results are compared. If a company posts earnings per share above the consensus number, they are generally thought to have achieved a "positive" earnings surprise and if they fall short of the consensus number, they have posted a "negative" surprise.

Consider the example of H&R Block Inc., which posted earnings per share of $0.06 for their quarter ended Jan. 31, 2001, beating First Call's consensus estimate of a $0.20 loss. In this case, the company posted a positive earnings surprise of $0.26. As often occurs after positive surprises, the company's stock price increased.

How Does the Market React?

Although the market's reaction to positive surprises is often favorable and its response to negative surprises is often unfriendly, these outcomes are far from guaranteed. Market reactions are hard to predict because they may depend on a variety of factors, including the magnitude of the unexpected result, the reasons for the surprise, and the implications for future earnings outcomes.

Under certain circumstances, a company may announce results that match or exceed analysts' estimates but then experience a share-price decline. For example, on Dec. 20, 2000, Palm Inc. reported quarterly pro forma earnings per share a penny higher than consensus expectations but its share price fell substantially following the announcement.

"Published analysts' estimates may not always fully reflect the market's true expectations for a given company. If many investors speculate that a business will outperform analysts' predictions, or grow accustomed to a company regularly besting published estimates, meeting or mildly beating the consensus forecast may be viewed as a disappointment." — Victoria Owens, analyst at mPower Advisors, LLC.

The decline following the company's positive earnings outcome may have stemmed from a variety of factors, including failure to exceed "whisper numbers" or rumors that circulated about the company's results prior to its official announcement. In Palm's case, the whisper numbers appeared to be higher than both analysts' published forecasts and the company's actual results, contributing to a share-price decline when these rumored expectations were not met.

The market's negative reaction underscores a key point about earnings surprises — published analysts' estimates may not always fully reflect the market's true expectations for a given company. If many investors speculate that a business will outperform analysts' predictions, or grow accustomed to a company regularly besting published estimates, meeting or mildly beating the consensus forecast may be viewed as a disappointment.

Yahoo! Inc.'s Jan. 10, 2001 earnings announcement provides an illustration of a company's stock falling after the company announced that it met earnings expectations for the quarter. At the same time Yahoo!'s management announced that their actual quarterly earnings were in line with consensus forecasts, they revealed that analysts' estimates for 2001 appeared unrealistically high. Yahoo!'s share price then fell.

This reaction illustrates that the actual earnings-per-share figure is not the only factor that can affect a company's stock price following an earnings announcement. Often, executives release other important information that may have a bearing on their company's long-term financial prospects at the same time they issue quarterly earnings numbers.

For instance, companies often release income statements and balance sheet data with their earnings reports. Details gleaned from these documents, including revenue growth, operating margins, debt levels, and inventory trends, are often scrutinized by analysts and investors in an attempt to arrive at estimates of future results.

In addition, members of corporate management often explain the factors that contributed to their company's performance during the past quarter and provide their outlook for future reporting periods through press releases and conference calls. If any of the trends revealed in a company's financial statements or commentary appear to indicate potential future problems, the company's share price may be severely affected — even if its current earnings results met expectations.

A company's share price may also remain unchanged or increase following a negative earnings surprise if investors believe that negative results will be short-lived. At the time of a negative earnings release, a company may announce new business forays, plans to cut costs, or management restructuring. If the negative earnings announcement does not appear to portend significant problems down the road, investors may overlook the earnings number and place greater emphasis on the other news.

Negative Surprises Can Affect Whole Industries

At times, an earnings surprise may have an impact on share prices for a full industry or market rather than just the individual company that posted unexpected results. If a company's earnings shortfall appeared to stem from weak demand, investors might ask whether those problems were specific to the company or indicative of broader sector or market trends.

For example, flagging sales at a bellwether personal computer manufacturer could indicate a decline in overall demand for computers and related products. If investors believe that the computer manufacturer's results foreshadow problems for other companies in the sector, this could affect stock prices for those businesses even if they have not issued negative reports.

"Managing" Expectations

Due to the rewards that often come from besting estimates and the declines that may occur following earnings misses, company officials sometimes strive to "manage" Wall Street's expectations. For example, they may try to guide analysts to expect lower figures than they actually believe their company will post, creating the possibility of a positive earnings surprise.

Managing investor expectations sometimes involves "preannouncements." If management is aware that their company's financial results are not playing out as Wall Street anticipated, they often announce their revised expectations prior to the close of the quarter. In the case of unfavorable preannouncements, or "earnings warnings," management may hope to mitigate blows to their share price and maintain their credibility within the investment community by providing information to investors early.

Mutual Fund Managers

Some mutual fund managers place great emphasis on earnings surprises and revisions. For example, managers who focus on earnings momentum often elect to buy stocks following upward earnings revisions or positive earnings surprises, and sell stocks immediately following disappointments.

Other managers concentrate more of their efforts on other areas. For example, many "value" managers focus on identifying financially strong companies that appear to be trading at low prices relative to their historical norms or other securities. Those managers might interpret a stock's plummeting price in reaction to a negative earnings surprise as a buying opportunity.

Ultimately, the amount of emphasis that a manager places on earnings surprises will depend on a variety of factors, including the manager's investment style and methodological orientation.

Related Reading What's Going On with Tech Stocks? Who Let the Bears Out?

Your Portfolio

Earnings surprises can have swift and severe effects on stock prices for a company, industry, or the market as a whole. So, how can investors protect their savings? The best answer is to maintain a portfolio that is diversified across securities, sectors, and asset classes. In this way, unfavorable surprises that are specific to individual companies or sectors will be less likely to have a dramatic impact on your portfolio. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Earnings Surprises

By Victoria Owens
Analyst, mPower

In This Story What Is an Earnings Surprise? How Does the Market React? Negative Surprises Can Affect Whole Industries "Managing" Expectations Mutual Fund Managers Your Portfolio

After the close of each fiscal quarter, Wall Street analysts, money managers, and individual investors anxiously wait for corporate earnings announcements to reveal whether companies have lived up to market expectations.

The marketplace often rewards the stocks of companies that surpass earnings estimates for the quarter and punishes those that fall short.

minute: read this article at a glance.

Technical Terms Earnings Sector Volatility

Earnings woes have been an important contributor to the market's recent volatility. Over the past several months, many companies disappointed Wall Street and suffered major stock price setbacks as a result. Earnings are now under a glaring spotlight as many investors worry about further surprises and some hope that earnings rebounds will boost their languishing stocks.

What Is an Earnings Surprise?

Earnings per share is a measure of a company's profit over a certain time period divided by the average number of shares outstanding during that span. For example, Microsoft Corporation posted net income of $2.624 billion over the three-month stretch ended Dec. 31, 2000. This figure, divided by the 5.570 billion average diluted shares outstanding during that period, resulted in earnings per share of $0.47 for the quarter.

"The marketplace often rewards the stocks of companies that surpass earnings estimates for the quarter and punishes those that fall short." — Victoria Owens, analyst at mPower Advisors, LLC.

This number is a common measuring stick for companies' performance. Investors often strive to assess stock values based on companies' estimated earnings for the coming years.

Stock analysts, often termed "Wall Street analysts," are hired by investment firms to evaluate the financial strength of companies and make buy-and-sell recommendations for those companies' securities. One major task for analysts is to project, or estimate, businesses' earnings growth for the coming fiscal quarters or years. Depending on the company and industry under consideration, analysts formulate their earnings estimates based on a variety of factors, including historical operating results, guidance provided by executives, industry demand trends, the quality of a business' product or service offerings, cost-efficiency initiatives, and a company's overall financial health.

Analysts' estimates for the coming quarters are compiled by a variety of sources, including Zacks Broker Research Report Service and First Call. These services calculate the average of analysts' estimates, or their "consensus" — a key benchmark against which companies' actual results are compared. If a company posts earnings per share above the consensus number, they are generally thought to have achieved a "positive" earnings surprise and if they fall short of the consensus number, they have posted a "negative" surprise.

Consider the example of H&R Block Inc., which posted earnings per share of $0.06 for their quarter ended Jan. 31, 2001, beating First Call's consensus estimate of a $0.20 loss. In this case, the company posted a positive earnings surprise of $0.26. As often occurs after positive surprises, the company's stock price increased.

How Does the Market React?

Although the market's reaction to positive surprises is often favorable and its response to negative surprises is often unfriendly, these outcomes are far from guaranteed. Market reactions are hard to predict because they may depend on a variety of factors, including the magnitude of the unexpected result, the reasons for the surprise, and the implications for future earnings outcomes.

Under certain circumstances, a company may announce results that match or exceed analysts' estimates but then experience a share-price decline. For example, on Dec. 20, 2000, Palm Inc. reported quarterly pro forma earnings per share a penny higher than consensus expectations but its share price fell substantially following the announcement.

"Published analysts' estimates may not always fully reflect the market's true expectations for a given company. If many investors speculate that a business will outperform analysts' predictions, or grow accustomed to a company regularly besting published estimates, meeting or mildly beating the consensus forecast may be viewed as a disappointment." — Victoria Owens, analyst at mPower Advisors, LLC.

The decline following the company's positive earnings outcome may have stemmed from a variety of factors, including failure to exceed "whisper numbers" or rumors that circulated about the company's results prior to its official announcement. In Palm's case, the whisper numbers appeared to be higher than both analysts' published forecasts and the company's actual results, contributing to a share-price decline when these rumored expectations were not met.

The market's negative reaction underscores a key point about earnings surprises — published analysts' estimates may not always fully reflect the market's true expectations for a given company. If many investors speculate that a business will outperform analysts' predictions, or grow accustomed to a company regularly besting published estimates, meeting or mildly beating the consensus forecast may be viewed as a disappointment.

Yahoo! Inc.'s Jan. 10, 2001 earnings announcement provides an illustration of a company's stock falling after the company announced that it met earnings expectations for the quarter. At the same time Yahoo!'s management announced that their actual quarterly earnings were in line with consensus forecasts, they revealed that analysts' estimates for 2001 appeared unrealistically high. Yahoo!'s share price then fell.

This reaction illustrates that the actual earnings-per-share figure is not the only factor that can affect a company's stock price following an earnings announcement. Often, executives release other important information that may have a bearing on their company's long-term financial prospects at the same time they issue quarterly earnings numbers.

For instance, companies often release income statements and balance sheet data with their earnings reports. Details gleaned from these documents, including revenue growth, operating margins, debt levels, and inventory trends, are often scrutinized by analysts and investors in an attempt to arrive at estimates of future results.

In addition, members of corporate management often explain the factors that contributed to their company's performance during the past quarter and provide their outlook for future reporting periods through press releases and conference calls. If any of the trends revealed in a company's financial statements or commentary appear to indicate potential future problems, the company's share price may be severely affected — even if its current earnings results met expectations.

A company's share price may also remain unchanged or increase following a negative earnings surprise if investors believe that negative results will be short-lived. At the time of a negative earnings release, a company may announce new business forays, plans to cut costs, or management restructuring. If the negative earnings announcement does not appear to portend significant problems down the road, investors may overlook the earnings number and place greater emphasis on the other news.

Negative Surprises Can Affect Whole Industries

At times, an earnings surprise may have an impact on share prices for a full industry or market rather than just the individual company that posted unexpected results. If a company's earnings shortfall appeared to stem from weak demand, investors might ask whether those problems were specific to the company or indicative of broader sector or market trends.

For example, flagging sales at a bellwether personal computer manufacturer could indicate a decline in overall demand for computers and related products. If investors believe that the computer manufacturer's results foreshadow problems for other companies in the sector, this could affect stock prices for those businesses even if they have not issued negative reports.

"Managing" Expectations

Due to the rewards that often come from besting estimates and the declines that may occur following earnings misses, company officials sometimes strive to "manage" Wall Street's expectations. For example, they may try to guide analysts to expect lower figures than they actually believe their company will post, creating the possibility of a positive earnings surprise.

Managing investor expectations sometimes involves "preannouncements." If management is aware that their company's financial results are not playing out as Wall Street anticipated, they often announce their revised expectations prior to the close of the quarter. In the case of unfavorable preannouncements, or "earnings warnings," management may hope to mitigate blows to their share price and maintain their credibility within the investment community by providing information to investors early.

Mutual Fund Managers

Some mutual fund managers place great emphasis on earnings surprises and revisions. For example, managers who focus on earnings momentum often elect to buy stocks following upward earnings revisions or positive earnings surprises, and sell stocks immediately following disappointments.

Other managers concentrate more of their efforts on other areas. For example, many "value" managers focus on identifying financially strong companies that appear to be trading at low prices relative to their historical norms or other securities. Those managers might interpret a stock's plummeting price in reaction to a negative earnings surprise as a buying opportunity.

Ultimately, the amount of emphasis that a manager places on earnings surprises will depend on a variety of factors, including the manager's investment style and methodological orientation.

Related Reading What's Going On with Tech Stocks? Who Let the Bears Out?

Your Portfolio

Earnings surprises can have swift and severe effects on stock prices for a company, industry, or the market as a whole. So, how can investors protect their savings? The best answer is to maintain a portfolio that is diversified across securities, sectors, and asset classes. In this way, unfavorable surprises that are specific to individual companies or sectors will be less likely to have a dramatic impact on your portfolio. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.