Analysts - Just Don't Follow Their Advice
Although analysts are paid big money to issue buy/hold/sell ratings on
stocks that they follow, my research shows that “buy” rated stocks don’t
perform any better than “hold” or “sell” rated stocks.
Nevertheless, there’s much to be gained by paying attention to analysts’
work, especially their earnings forecasts. Here’s why.
Prices Reflect Expected Growth
All else equal, share prices reflect the underlying firm’s expected
earnings growth. Stocks with strong expected growth usually trade at
higher valuations than slower growers.
Analysts forecast earnings for the current and next quarters, as well as
for the current and next fiscal years for the stocks that they cover.
Research firms such as Thomson Financial average the individual forecasts
to come up with consensus earnings forecasts.
You can see the consensus forecasts on many financial sites. On Yahoo (finance.yahoo.com)
for example, get a price quote and then select
Estimates. Yahoo lists the consensus forecasts (Average Estimate) for
the current and next quarters, and for the current and next fiscal years.
If you’re using Yahoo, scroll down to the bottom to see the estimated
growth expressed as a percentage. Pay most attention to the fiscal year
During normal times, most growth investors look for stocks expected to
grow earnings at least 20% annually, and higher
is better. However, given current conditions, 15%
would be considered good. For example, Google, a growth company in the
eyes of many investors, is only expected to grow earnings by 17% this year
and 16% in 2010.
Trends Most Significant
Earnings forecast changes are even more significant than the growth
percentages. Share prices usually move up when the consensus forecasts
rise, and drop when the forecasts are revised downward. Interestingly, the
consensus forecasts often move in trends. That is, once forecasts start to
move, either up or down, they often continue on the same path for a few
Why does that happen? It could be that once one analyst makes a change,
others reexamine their assumptions to see if they’ve missed something.
Apparently, many times, they decide that they have and revise their
forecasts in the same direction, which drives the share price further up
But there’s more to the story. Trending estimates often predict a
corresponding earnings surprise when the firm reports its quarterly
results. An earnings surprise is the difference between analysts’
forecasts and reported earnings. It’s a positive surprise when earnings
exceed forecasts and a negative surprise if they fall short. A positive
earnings forecast trend predicts a positive surprise, and vice versa.
Significant positive surprises, say more than two cents per share,
typically drives the share price higher. Any negative surprise, even one
cent per share, usually drives the share price down. Share prices usually
drop more in response to negative surprises than they gain for positive
surprises. Thus, it’s especially important to notice when earnings
forecasts are trending down, warning of a potential negative surprise.
The EPS Trends section of Yahoo’s Analyst Estimates report shows the
current and historical earnings estimates going back three months. Pay
most attention to the fiscal year numbers and ignore one-cent changes.
When I looked, Google December 2009 fiscal year forecasts had increased
two-cents over the past month, 22 cents over the past two months and $1.07
over the past 90-days. That strong positive earnings forecast trend
signals that Google is likely to surprise on the upside when it reports
its December quarter results, probably in late January.
Nothing always works in the stock market, and analyzing earnings forecast
trends is no exception. Nevertheless, it would be a useful addition to
your analysis toolbox.