What do Analyst Estimates Really Mean, and How do They Affect Stock Prices?

For investors, there may be nothing quite as nerve-racking as earnings season. Even if a company posts big profits or massive revenues, missing analysts’ estimates can send its stock price tumbling. On the other hand, unexpected growth can make those shares soar.

The ups and downs can be confusing to investors. Why would a stock suffer if the company is still doing well? “It’s like the New England Patriots when they had Tom Brady,” says Brian Madden, a chartered financial analyst and chair of the board of CFA Society Toronto. “You know they’re always going to do well, but people wanted them to do even better than what was expected.”

Analysts aren’t just the equivalent of commentators opining on the game’s score, they’re there to help investors gain a better understanding of how successful a company could be in the future. They do that by looking at historical figures (the numbers companies put out on a quarterly basis) to identify trends, and pulling information from a variety of sources, including data on other companies in the same industry, broader sector trends, consumer spending expectations and more to see where a business may go down the road. “The market is forward looking,” explains Madden. “While accounting studies a company’s historical results, analysts are experts in learning from the past to project the future.”

Analysts will forecast what a company’s earnings might be for a quarter or a year and how they expect the business will grow, and then estimate what that business might be worth compared to how the market is valuing its peers. While investors can then use those figures to make a more informed decision on whether to buy or sell a stock, it also helps to get a sense of what a company’s share price is worth.

No matter the business, markets price in an assumed rate of growth for a company. The consensus estimate, which is an average of the numbers the various analysts release, is one of the best ways to understand what that assumed rate of growth might be.

Making these projections might seem like a black art at times, but there’s science behind it, too – analysts do plenty of painstaking work to come up with these potentially market-moving figures.

Building forecasts

Analysts use financial modelling to predict how a company will perform over time. This process often includes speaking with an organization’s management team about its products, customers and market potential; studying its offerings; and scrutinizing its financial information, such as sales, recurring revenues and expenses. Depending on the sector and company they’re looking at, analysts may also consider macro-economic data including population growth, consumer spending and immigration.

Analysts are often experts in a particular industry or area of the economy, such as real estate, health care or technology. This specialization gives them a deep knowledge of the environment a company is operating in, which provides them with a good understanding of the key variables that could help or hinder its success.

With the real estate industry, for example, an analyst might be interested in metrics such as occupancy rates, average rents and maintenance costs. If looking at telecom companies, they’ll consider things like customer churn (the movement of customers from to one carrier to another), how immigration could impact sales, the current average revenue per user and more.

While analysts do often interview executives of the companies they cover, they’re not privy to real-time information from the business. They only have access to public information that is available to all investors, which makes analysis more complicated to do. “It’s quite involved because analysts don’t have all the data they’re using to project future results,” says Madden. “They’re making their best-informed judgment as to what the future is going to look like.” It’s the way they put all this information together using their deep knowledge of financial analysis and a particular company or industry that allows them to create valuable forecasts.

After all the numbers are crunched, an analyst will produce a report that contains key financial projections about a company, including earnings per share, cash flow and revenue numbers for the quarter and fiscal year. Given how many analysts typically study a stock, investors tend to look at consensus estimates, which are an average of the numbers the various analysts release.

Moving markets

These estimates can have a significant impact on investors – even missing by a few pennies can trigger a negative market reaction. “It’s a case of setting the bar high and not reaching that bar,” says Madden, “A stock can trade down even though the company reported 20 or 30 per cent earnings growth compared to last year.”

A difference between projected future results and actual reported financial results sometimes causes unexpected price swings. For instance, a company may beat analyst expectations, but if it announces some of their future earnings may not be as strong as initially anticipated, then that forward guidance may draw the stock down. The other thing that can sometimes happen is that a company meets or beats expectations overall, but one or more segments of the business disappoints (for example, a company may have done well on its overall sales, but come up short on their cloud revenue), and this negatively affects its price.

Because of how the market can react, it may be helpful for investors to stay grounded while paying close attention to the real-world results found in an organization’s quarterly reports. If a company fails to meet a consensus estimate, you might want to do some research and ask yourself if the miss seems like a one-off or if it’s indicative of a trend. Did the company outperform its previous quarter? Does its competitive advantage appear to be widening or shrinking? Are its margins improving or getting worse?

“There’s a fine line between not overreacting to a company having a small miss against the consensus estimate versus burying your head in the sand and not paying attention to new and emerging information that should prompt you to rethink your thesis,” Madden says. Ultimately, this involves recognizing that there are two competing spheres of influence at work: real-life performance and how results compare to expectations. “The results in real life drive the performance of a company’s stock over the long-term,” Madden says. “In the short-term, it’s about managing expectations.”

The challenge for investors, he adds, “is to discern whether something is short-term noise or something changing in the underlying fundamentals – it’s not always easy.”