There are four earnings calls each year that have a critical impact on a stock. These events coincide with what is known as earnings season. A time where companies release their quarterly earnings results to the public. A company’s earnings can drive it’s stock price up or down. But how do we know how good an earnings release really is?
Earnings are so important that a whole sub industry has been created just to study a company’s future earnings potential. Analysts, as their called, release an earnings forecast or estimate, which can have a big impact on a stock price. I use the term “forecast” loosely, analysts like weathermen, can often be wrong. That being said, a the stock price is tied to how well a company’s earnings compare to the average analysts estimate. If a company beats the estimates, the stock usually rises in value. And does the opposite if it fails to meet the estimates.
The Analyst Estimate
An analyst is charged with studying an industry and the publicly traded companies within it. Companies in the same industry do business in similar ways, have similar products and services, and tend to react similarly to economic changes. By studying these things, the analyst can make an educated guess to a companies future earnings, provide a stock rating, and a potential target stock price if their estimates are achieved.
If you own stocks or have a brokerage account, you’ll come across analyst estimates being revised, upgraded, updated, initiated, downgraded and the stock price will move entirely on these changes. This happens because the market is starving for information.
Depending on the stock, the number of analysts covering it varies. Companies that make headlines tend to have more analysts following them. The more analysts covering a stock, the better chance the average estimates are accurate. It also gives you a better comparison for your own research.
The Ratings Game
When analysts estimate earnings they also recommend or rate a stock, they do so based on how the stock will perform against other companies in the same industry. So if a stock is given the highest rating, it doesn’t mean it should perform better than every other stock, just better than it’s peers. Which really isn’t saying much.
Say Company XYZ’s stock is given the highest rating and ends the year down 10%. If every other stock in Company XYZ’s industry end the year lower than 10%, then the analyst was right. The rating doesn’t tell the whole story.
For some reason each investment and brokerage firm that offer ratings seem to have their own system. One firms highest rating may be “Buy” while another firms might be “Strong Buy” or “Recommended List”. So take each rating with a grain of salt. Listed below are several often used ratings and their equivalents.
- Strong Buy – Recommended List
- Buy – Outperform, Moderate Buy, Accumulate, Overweight
- Hold – Neutral, Market Perform, Peer Perform
- Underperform – Market Underperform, Moderate Sell, Weak Hold, Underweight
- Sell – Strong Sell
Be wary of investing purely off of analysts recommendations. Many analysts work for investment or brokerage firms. The analyst or the firm may own shares themselves. The firm may simply do other business with the company and may want to see a higher rating. It’s much better to use the recommendations and estimates as a comparison to your own investment research.