Can a positive earnings surprise be faked?
During quarterly earnings season, when companies report their earnings, and they are immediately compared to the Wall Street Analyst estimates. If the reported earnings beat estimates, then this is called a positive earnings surprise, if they don’t, then that is an earning miss. Trust me, companies want to beat the estimates. An earnings miss can crater a stock, and generally shows that management may not have a good grasp of their business.
In general, for every one negative surprise there are three positive surprises. How is it possible for so many companies to beat earnings? Some companies legitimately have a great quarter, and outperform the analysts’ estimates. However, other companies move the yardstick shortly before earnings announcements.
They do this by issuing forward-looking guidance that looks weaker than analysts estimates. Analysts then lower their estimates. Then once the estimates are lowered, the company triumphantly announces their earnings, and it beats estimates by a penny. It should be noted that when estimates are lowered, usually a company’s stock price gets hit.
How do you find the companies that truly beating earnings?
Look for these factors:
- Earnings that are increasing year over year. If a company is growing, often upward estimate revisions often fail to catch up with this growth.
- Estimate Trend that is increasing. If estimates are going up, it is harder to argue that the company has massaged them down.
- Strong Chaikin Money Flow. If institutions are investing in the company, there is a good chance that the growth is real.
The payoff for investors is picking companies with strong earnings, and the potential for more. There is a virtuous cycle with a positive earnings surprise. First, the market rewards companies that have legitimate positive surprises, and then analysts raise estimates for future quarters giving the stock a second lift.
Another rule of thumb is that Earnings Surprises come in bunches. This means that companies that beat estimates tend to continue to beat estimates. So pay attention to Earnings Surprise and look at these three factors.