Whether an earnings surprise is positive or negative matters, as it can influence stock prices and trading activity. That’s important to understand if you hold stocks in your portfolio.
Definition and Example of Earnings Surprise
An earnings surprise is a positive or negative deviation from a consensus earnings estimate. Individual financial analysts put together earnings estimates ahead of earnings season. These estimates represent the analysts’ best guesses about a company’s valuation and growth potential. Multiple earnings estimates from individual analysts are then used to create a consensus earnings estimate. Once a company releases its quarterly or annual earnings report, those numbers are compared with the earnings estimate. If earnings are substantially higher or lower than what was expected, the result is an earnings surprise. For example, for the fiscal quarter ending September 2021, Microsoft (MSFT) reported a 10.19% earnings surprise. This means the company’s earnings for the quarter beat the analysts’ earnings estimate by 10.19%.
How an Earnings Surprise Works
Stock market analysts study various pieces of information and financial data to develop an accurate earnings estimate. In doing so, the analysts are trying to gauge the earnings per share (EPS) the company will report for the quarter or the year. Earnings per share is a company’s net profit divided by its outstanding shares of common stock. So why is that important? In simple terms, earnings per share tells you how much money a company makes for each share of common stock issued. When a company has a higher EPS, this can suggest that it also has a higher valuation. That can make it more attractive to investors and the market as a whole. An earnings surprise happens when there’s a wide gap between earnings estimates and actual earnings reported. Specifically, the EPS the company reports is not the same as what was predicted by the consensus analyst forecast. Earnings surprises can be positive or negative. A positive earnings surprise means the company outperformed expectations or beat its earnings estimate. A negative earnings surprise means the company underperformed, relative to the expectations set by the earnings estimate. Going back to the example of Microsoft, the consensus forecast called for an EPS of 2.06 for the fiscal quarter ending September 2021. When the company’s earnings report was released in October 2021, the actual earnings per share worked out to 2.27. Hence, the 10.19% positive earnings surprise. For the fiscal quarter ending December 2020, Microsoft reported an EPS of 2.03 versus the 1.64 that was projected, for an even bigger earnings surprise of 23.78%. Coinbase (COIN), meanwhile, delivered a negative earnings surprise of -9.5% for the fiscal quarter ending September 2021, falling short of the consensus forecast. This was after the company had a stunning positive earnings surprise of 157.83% for the fiscal quarter ending June 2021. Both examples illustrate how difficult it can be for analysts to pinpoint a company’s valuation and earnings with 100% accuracy.
What It Means for Individual Investors
Understanding earnings surprises matters if you own stocks for one simple reason. Whether a company beats its earnings estimate expectations or falls short can influence its stock price. When a company surpasses its earnings estimate and has a positive earnings surprise, that can send a signal to the market that it’s a buy. As more traders purchase shares, that can push the stock’s price up. Any shares you already own would be worth more and you could potentially sell them for a sizable profit. On the other hand, a negative earnings surprise could push stock prices down. If investor sentiment toward the company turns negative, you might see a sell-off happening. The more shares that are sold, the more the stock’s price could drop. So if you own shares in that scenario, you could lose money. It’s important to consider the bigger picture, however. One poor earnings quarter doesn’t necessarily indicate that a company is spiraling. Coinbase is a great example of a company that had both positive and negative earnings surprises in 2021. Looking at a company’s fundamentals can give you a better idea of how healthy it is financially, versus focusing on a single earnings report. For example, you might consider price-to-earnings ratio (P/E) ratio, debt-to-equity ratio, or return on equity (ROE), in addition to earnings per share to get a clearer picture of how much money a company is bringing in, how much it spends, and how much debt it has on its balance sheet.
