Earnings Compared to Expectations

If you’re a casual observer of markets, you might think that the most important thing that a company can do is beat analyst expectations of earnings.  Markets help to reinforce that view because individual stocks often jump by significant amounts after earnings reports and the financial media usually focuses its earnings summaries on whether or not a company “beat” or “missed” and by how much.

About half of the S&P 500’s constituents have reported earnings so far this quarter and, according to Factset, a whopping 73%, have beaten estimates.  That sounds like a great number, but in reality it doesn’t give a clear picture of whether company earnings over the whole period have been successful or disappointing.

Analysts revise earnings estimates right up until a company’s earnings report, so really all it means when a company beats earnings is that it did better than analysts expected it to based on information that analysts had up to that day.  To get a better sense of how companies really did relative to expectations, it might be more proper to compare actual earnings to the expectations that existed before the quarter started.

The earnings game is like betting on a horse race a few lengths from the finish line.  You’ll have a better chance of guessing which horse is going to win, but that doesn’t tell you anything about how the horses did relative to how they “should” have done.  To really understand if a horse met expectations you have to look at the lines set by handicappers before the race began.

When you look at this quarter’s earnings relative to what analysts expected before the quarter started, the beat rate isn’t quite as astronomical.  Only 45% of companies have beaten the estimates that were set on December 31, before we got to see any of the race unfold.

Real Earnings Beat Rate

 

Source: Factset, Compustat Data, Avondale

Note: there were some challenges in putting this data together, but I think I caught most of the errors that could have skewed the data set.  I’m fairly confident that the conclusion is valid, but because I can’t be certain, a special caveat is needed.  That 45% number should be taken with some assumed margin of error.