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Pay Attention to 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 Analysts 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 forecasts.

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 weeks.

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 or down.

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.

Surprises Count
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.

published 12/20/09

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