Earnings season can be an eventful time for investors.
Prices can jump significantly depending on how companies' earnings results compare
to expectations.
These expectations come from two main sources: analyst earnings estimates and a company's
own earnings estimates, often called company guidance.
Because of the potential effect of these estimates on stock prices, it's important to understand
where they come from and what they mean to you.
Let's start with analyst earnings estimates.
Analysts are financial professionals who typically work for brokerage firms, investment advisors,
banks, or mutual funds.
They usually specialize in specific industries or sectors and develop expertise in evaluating
investments in those areas.
Analysts use their knowledge to project how much a company might earn over a certain time
frame, usually a quarter.
Projecting performance over just a few months may not sound that difficult, but with all
the factors that can affect a business's performance, it's actually a complex endeavor.
Analysts conduct research like reviewing past performance, studying economic trends, and
meeting with company management.
Analysts also draw significantly on company guidance, which is the second main source
of earnings expectations.
As part of quarterly earnings announcements, companies typically share estimates of their
future performance.
This guidance reflects the internal expectations for sales and earnings for future quarters
or years, and reveals management's perspective on industry and macroeconomic trends.
Analysts combine company guidance with their own research and sophisticated financial models
to forecast earnings.
Analysts then publish their estimates.
A large company may be closely followed by dozens of analysts from different firms, and
because each analyst may use different models, their estimates can vary dramatically.
Many investors use a consensus, or average estimate, against which actual earnings results
are judged.
Analysts may also publish recommendations for the stock such as a "buy", "sell",
or "hold" and explain in detail the merits of their analysis.
Analyst estimates represent the research and insight of knowledgeable professionals, which
can be a helpful touchpoint as you form you own opinions about an investment.
However, estimates vary, and earnings surprises happen.
Forecasting financial performance isn't an exact science, and relying solely on analyst
estimates is risky.
Although analysts are highly qualified professionals with access to the best data and tools, they
can still make faulty assumptions.
For example, the company guidance on which analysts base some of their forecasts can
be overly optimistic or overly conservative.
Furthermore, unexpected events can swiftly and drastically change an investment's outlook,
no matter what analysts have said.
Some critics also note that Wall Street analysts can be vulnerable to unique biases.
For example, some analysts work for firms that provide banking or other services to
the companies they analyze.
This relationship may pressure analysts to provide positive ratings so they don't lose
favor with these firms.
Other analysts may be threatened with loss of access to management's time and insight
if they issue a negative recommendation.
Studies have shown that analysts have been consistently overconfident in their recommendations.
For example, during the dot-com bubble, many analysts were criticized for maintaining "buy"
ratings on questionable stocks even as they were collapsing.
In spite of these risks, earnings estimates can play a significant role in earnings announcements it's
these numbers that companies are expected to beat.
Even before actual earnings are released, if a large number of analysts are in agreement,
the market may react by pushing the stock price in one direction or another.
Analyst estimates and company guidelines are valuable tools.
Just remember to carefully weigh their opinions with other forms of analysis when making an
investment decision.