What Is an Earnings Surprise?

What Is an Earnings Surprise?

An earnings surprise occurs when a company's reported quarterly or annual profits are above or below analysts' expectations. These analysts, who work for a variety of financial firms and reporting agencies, base their expectations on a variety of sources, including previous quarterly or annual reports and current market conditions, as well as the company's own earnings' predictions or "guidance."

Breaking Down Earnings Surprise

In order to create an accurate forecast of how a specific company’s stock will perform, an analyst must gather information from several sources. They need to speak with the company’s management, visit that company, study its products and closely watch the industry in which it operates. Then, the analyst will create a mathematical model that incorporates what the analyst has learned and reflects their judgment or expectation of that company’s earnings for the forthcoming quarter. The expectations may be published by the company on its website, and will be distributed to the analyst’s clients. A surprise occurs when a company reports numbers that deviate from those estimates.

Earnings surprises can have a huge impact on a company's stock price. Several studies suggest that positive earnings surprises not only lead to an immediate hike in a stock's price, but also to a gradual increase over time. Hence, it's not surprising that some companies are known for routinely beating earning projections. A negative earnings surprise will usually result in a decline in share price.

Publicly traded companies also issue their own guidance outlining expected future profits or losses. This forecast helps financial analysts set expectations, and can be compared to get a better idea of potential company performance in the upcoming quarter.

Earnings Surprise and Analyst Estimates

Analysts spend an enormous amount of time before companies’ reporting their results, trying to predict earnings per share (EPS) and other metrics. Many analysts use forecasting models, management guidance, and additional fundamental information to derive an EPS estimate. A discounted cash flows model or DCF is a popular intrinsic valuation method.

DCF analyses use future free cash flow projections and discount them via a required annual rate. The result of the valuation process is a present value estimate. This, in turn, is used to evaluate the company’s potential for investment. If the value arrived at through the DCF is higher than the current cost of the investment, the opportunity could be a good one.

The DCF calculation is as follows:

Analysts rely on a variety of fundamental factors in the companies’ SEC filings (e.g., SEC Form 10-Q for a quarterly report and SEC Form 10-K for its more comprehensive annual report). In both reports, the management discussion and analysis (MD&A) section provides a detailed overview of the previous period’s operations, how the company performed financially, and how management is planning to move forward in the coming reporting period.

Management's discussion and analysis dig into specific reasons behind aspects of company growth or decline on the income statement, balance sheet, and statement of cash flows. The section breaks down growth drivers, risks, even pending litigation (often also in the footnotes section). Management also frequently uses the MD&A section to announce upcoming goals and approaches to new projects, along with any changes in the executive suite and/or key hires.