Why is it So Easy to Beat Wall Street Expectations?

Last Friday was one of the best days for capital markets in recent years and especially so for those holding some tech stocks, which gained the most. The Nasdaq 100 rose by almost 3%, led by technology juggernauts, such as Amazon, Google, Microsoft, and Intel. All of them beat the “Street Expectation,” which is a term used to describe the average estimate for a company’s quarterly revenues, earnings, and other important financial data that a public company has to report every quarter.

The drill is almost routine for those following capital markets—a company delivers its earnings report (usually after the closing bell), and immediately financial networks report what happened, using such words as “beat” or “miss.” Investor reaction varies by the extent of the beat or the miss, but essentially a beat yields a green day for a stock, whereas a miss might be a day investors would want to forget.

Large companies are covered by dozens of analysts, who provide expectations for the following quarters (and years) and determine the value of a company based on what they expect will happen. If the value exceeds the market price, they recommend buying the stock. If the price exceeds the value, they would advise selling the stock.

Analysts’ estimates are combined with figures usually referred to as Consensus Estimate. The most important figures are earnings per share and revenues per share. These will set the destiny of the stock for the coming days after the earnings release.

Market reaction is usually related to the state of the market. In today’s bull market, every beater can expect a nice day, and the bigger the beat, the bigger the market reaction (it works the opposite for a miss).

In a totally random world, it would be reasonable to expect that the number of beats and misses would be approximately the same, assuming that the estimates are indeed fair. But are they?

What the Numbers Tell Us

According to Factset report for the third quarter of 2017, 76% of S&P 500 companies reported a beat for the EPS (earnings per share), and 67% reported a beat for revenues (out of the 55% of companies that have already reported). The results in Seeking Alpha report for the first quarter of 2017 are less unequivocal, with 61% of 2,450 public companies reporting a beat, which is still a certain majority for the beaters. Historical data shows that approximately two-thirds of companies beat analysts’ expectations.

Apparently, this is not a random and rational world. Some possible explanations for this situation include the following:

  • Companies manage the expectations—Punishment for a miss is much higher than the reward for a beat. It’s a chicken and the egg problem—most companies beat; therefore, beating is not a surprise, and the reward does not equal the punishment for a company miss, which makes companies try to eliminate the chance of missing. Thus, companies try to affect analysts’ expectations through information they provide in meetings, press conferences, and even in the previous quarter’s earnings release.
  • Equal expected value—According to the reports of Factset and Seeking Alpha, companies that beat expectations in 2017 saw an average gain of 1.6%–2% the following day, while companies that missed saw an almost double decline of 3.2%–3.4%. Therefore, if the potential decline is twice as much as the potential gain and the number of companies that beat doubles the number of companies that miss, the total expected value of the stock market’s reaction to the reports would be close to zero.
  • Better accountants? The biggest companies are beating the consensus estimate most of the time. Some notable Dow Jones companies have beaten expectations more than 80% of the time. This result could also be related to better management of expectations or maybe just having better accountants. Statistically, I would expect to see bigger companies report results that are equal to expectations since those companies are covered by more analysts, which makes the consensus estimate a figure that is based on the average of many analysts.
  • Overly pessimistic—Managers and analysts don’t want to risk seeing results worse than they initially expected. By taking the side of caution, they guarantee not to be blamed for a miss.

For those new to the market . . .

Yes, statistics show that most stocks beat expectations. Still, don’t try to guess which ones will beat and which ones will miss. Market dynamics indicate that stocks that miss are getting crashed, and you don’t want to be there when it happens. If you’re a long-term investor, all of this doesn’t matter, as these fluctuations don’t change the long-term value of the company.

 

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