Earnings Forecasts: A Primer

Most people who read the financial press or watch financial news will have heard the term "beat the street." This refers to companies posting earnings results that are better than the forecasts for earnings made by investment and financial analysts.

Wall Street analysts' consensus earnings estimates are used by the market to judge stock performance. Here we offer a brief overview of consensus earnings forecasts, and what they can mean to investors.

Key Takeaways

Large brokerages hire analysts to publish reports on various corporations' upcoming profit announcements, including earnings-per-share and revenue forecasts.
Consensus earnings estimates refer to the average or median forecast of what a company is expected to earn or lose for a given period of time, typically quarters and full years.
While there are some flaws in the system, consensus estimates are perceived as significant for understanding a stock's valuation.
They are monitored by investors and the financial press.
Whether a company meets, beats or misses forecasts can have an impact (usually short term) on the price of its underlying stock.

What Are Consensus Earnings Estimates?

Investors measure stock performance on the basis of a company's earnings power.

To make a proper assessment, investors seek a sound estimate of this year's and next year's earnings per share (EPS), as well as a strong sense of how much the company will earn even further down the road.

That's why, as part of their services to clients, large brokerage firms employ legions of stock analysts to forecast companies' earnings for the coming years.

Consensus earnings estimates or forecasts are normally an average or median of all the forecasts from individual analysts tracking a particular company and its stock.

Consensus earnings estimates are far from perfect, but they are watched by many investors and play an important role in measuring the appropriate valuation for a stock.

Various Forecasts, One Average

When you hear that a company is expected to earn $1.50 per share this year, that number could be the average of 30 different forecasts.

On the other hand, if it's a smaller company, the estimate could be the average of just one or two forecasts.

A few companies, such as Refinitiv and Zacks Investment Research, compile estimates and compute the average or consensus.

Consensus numbers can also be found at a number of financial websites, such as Yahoo! Finance. Individual estimates are found by looking up a particular stock, such as Amazon.

Some of these sites also show how estimates get revised upward or downward.

Important

Consensus earnings estimates are not fixed. Analysts typically revise their forecasts as new information comes in, such as company news, or regulatory or industry-specific information.

Forecast Coverage

Consensus estimates of quarterly earnings are published for the current quarter, and forward for about eight quarters.

In some cases, forecasts are available beyond that. Forecasts are also compiled for the current and next 12-month periods.

A consensus forecast for the current year is reported once the actual results for the previous year are released.

As actual numbers are made available, analysts typically revise their projections within the quarter or year they are forecasting.

Calculating Earnings

The basic measurement of earnings is earnings per share. This metric is calculated as the company's net earnings—or net income found on its income statement—minus dividends on preferred stock, divided by the number of outstanding shares.

For example, if a company (with no preferred stock) produces a net income of $12 million in the third quarter and has eight million shares outstanding, its EPS would be $1.50 ($12 million/8 million).

The Importance of Earnings

Investors can keep an eye on consensus numbers to gain an idea of how a stock is likely to perform.

Many investors, including sophisticated institutional investors such as mutual fund and pension fund managers, rely on earnings forecasts to gauge a company's growth potential and to time their trades.

Stocks are assessed according to their ability to generate and increase earnings as well as to meet or beat analysts' consensus estimates for earnings.

This influences a company's implicit value (the personal perceptions and research of investors and analysts), which in turn can affect whether a stock's price rises or drops.

Analysts' forecasts also are critical because they contribute to investors' valuation models.

Institutional investors can move markets due to the volume of assets they manage. They follow analysts at big brokerage houses to varying degrees.

Earnings vs. Other Results

Why does the investment community focus on earnings rather than other metrics such as sales or cash flow?

First, any finance professor will tell you that the only proper way to value a stock is to predict the long-term free cash flows of a company, discount those free cash flows to the present day and divide by the number of shares.

But this is much easier said than done, so investors often shortcut the process by using accounting earnings as a substitute for free cash flow.

Secondly, accounting earnings are a much better proxy for free cash flow than sales. They're also fairly well defined. And public companies' earnings statements must go through rigorous accounting audits before they are released.

As a result, the investment community views earnings as a fairly reliable, not to mention convenient, measure.

Fast Fact

Most investors, including large institutions, lack the resources to track thousands of publicly-listed companies in detail, or even to keep tabs on a fraction of them. So they welcome consensus earnings forecasts.

The Basis of Analysts' Forecasts

Earnings forecasts are based on analysts' expectations of company growth and profitability. To predict earnings, most analysts build financial models that estimate revenues and costs.

Many analysts will incorporate top-down factors such as economic growth rates, currencies, and other macroeconomic factors that influence corporate growth.

They use market research reports to get a sense of underlying growth trends. To understand the dynamics of the individual companies they cover, really good analysts will speak to customers, suppliers, and competitors.

In addition, companies themselves offer earnings guidance that analysts build into the models.

Revenues

To predict revenues, analysts estimate sales volume growth and the prices companies can charge for products.

On the cost side, analysts look at expected changes in the costs of running the business. Costs include wages, materials used in production, marketing and sales costs, interest on loans, and more.

Important

Consensus estimates are so consistently tracked by so many stock market players that when a company misses forecasts, it can send a stock tumbling. Similarly, a stock that merely meets forecasts might get sent lower, as investors have already priced in the in-line earnings.

Actual Earnings vs. Consensus Estimates

Consensus estimates of earnings are so powerful that even small deviations between estimates and subsequent reports of actual earnings can send a stock higher or lower.

If a company exceeds its consensus estimates, it is usually rewarded with an increase in stock price. If a company falls short of consensus numbers—or just meets expectations—its share price can take a hit.

With so many investors watching consensus numbers, the difference between actual and consensus earnings is perhaps the single most important factor driving share price performance over the short term.

This should come as little surprise to anyone who has owned a stock that missed the consensus by a few pennies per share and, as a result, tumbled in value.

For better or for worse, the investment community relies on earnings as its key metric. Stocks are judged not only by their ability to increase earnings quarter over quarter but also by whether they are able to meet or beat a consensus earnings estimate.

Why Do Earnings Matter?

One reason they matter is because a company with growing net income, or earnings, is growing in value. Investors who own the stock of such a company should see the price of their shares rise. That, in turn, increases the overall value of the investors' portfolio and their wealth.

How Can Analysts Forecast a Company's Earnings?

Publicly traded companies are required by the Securities and Exchange Commission to make financial details public. In addition, companies often provide guidance for analysts and investors concerning their future financial results. So analysts can research a wealth of data to come up with their estimates for earnings.

How Do Companies Give Earnings Guidance?

A good source of earnings guidance is the Management Discussion and Analysis (MD&A) section of the annual report. There you'll find information on a company's financial condition and results of operations, including analysis and financial projections.

The Bottom Line

Financial analysts provide earnings forecasts in advance of actual earnings reports so that investors can gauge a company's performance and stock valuation.

For convenience, the figures of many forecasts are averaged and become a consensus earnings forecast that investors may use to size up their investments and to make trade decisions.