What is an Earnings Surprise?

What is an Earnings Surprise?

Investors are always surprised at the market reaction towards a company’s financial performance. There were times when retail investors were expecting the stock prices to increase after the respected companies posted good results with healthy earnings growth only to get caught by the counter intuitive reaction of the market which lowers the stock prices leading towards loss instead of profit. Likewise, there are also cases where the stock prices of companies which posted losses reacted positively.

Whenever a listed company announces its quarterly results and the stock price of the company reacts to the announcement either positively or negatively, the market will say that the price movement is due to the company’s earnings surprises. Earnings surprises occur when a company reports actual earnings that significantly deviate from market expectations, which in turn will determine if a particular stock price is going to gain or lose when actual earnings are reported. Positive earnings surprises arise from reported earnings that are significantly above the consensus forecasted earnings while negative earnings surprises are when reported earnings come in significantly below the earnings expectations. At the end of this article, you will be able to identify what are earnings expectations and how they affect your investment decisions.

What Are Earnings Expectations?

Earnings Expectations come about in many ways. It could be based on interactions between investors and analysts’ opinions regarding factors such as market prospects, revenue growth potential, sustainable competitive advantage or operation efficiency.

It could also be based on stocks with earnings estimates coming from an analyst who has been tracking and analyzing them. Collectively, these estimates from various analysts, although could sometimes be of different views, may form a common agreement. By looking at the number of estimates provided by analysts, investors can have a feel for the depth of coverage to a particular company.

There is also a revision to the earnings estimates by the analysts before the actual announcement, which may reflect changes in expectations of future performance due to changes in the economic outlook. It could also be due to company specific changes that will affect the company prospects, such as the launch of a new product or an upcoming merger. Earnings revisions often serve as precursors to earnings surprises. As the reporting period approaches, estimates normally converge towards the consensus view.

As the stock market is always forward looking, before a company’s actual earnings being reported, the stock price would already have reflected all the known factors that could have had an impact on the future earnings power of the company. Therefore, it has basically considered all of the known good and bad news expected from the companies. That is the reason why when the actual results from the company is still significantly different from the market consensus, it catches the market by surprise.  If the market is expecting the company to do badly, while the actual results show that even though the company loses money but not to the extent that the market has expected, the market will take it as good news and react with an upward adjustment to the stock price.

Sources of Earnings Surprises

There are countless possibilities that could cause earnings surprises. As analysts and investors in general are not in the company, they can only form their estimates and assumptions based on the known facts that are announced to the public. However, there are still many situations that the company faces or various measures that the company plans to take that are not made known to the public. Examples of causes include high outstanding account receivables and excessive inventory build ups, new entrance into the market which may threaten the company’s competitive position, delay or failure in introducing a new product or services that is much awaited by the market, unexpected changes in the accounting policies or accounting estimates just to name a few.

Impact of Earnings Surprises to Stock Prices

Usually an earnings surprise has immediate impact on the stock’s price. However, sometimes the effect may stay on for a longer time. Therefore, it may not be too late to buy a stock that has just experienced a positive earnings surprise, even though we can’t react right at the time of the initial surprise. Likewise, it is also not advisable to purchase a stock right after the initial price decline of a negative earnings surprise, since there is a possibility that the stock will continue its down trend for some time. Some larger firms tend to adjust to surprises faster than small firms do as they are tracked by more analysts and portfolio managers, who are quite efficient and react swiftly.

In any case, earnings estimates and earnings surprises are important elements to be considered when we do our stock selection.

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*Note: This article was written by Mr Ooi Kok Hwa, holder of the Capital Markets Services Representative’s License to carry on the business of investment advice under the Capital Markets and Services Act 2007. The information provided in this article is only for educational purposes and reflects the market conditions at a specified point in time, which may lapse and affect the relevance of this article. This article does not necessarily represent the official view of Securities Industry Development Corporation and should not be used as a substitute for legal or other professional advice.