What is an earnings surprise?

Personal Investment - A column by Ooi Kok Hwa

Clearing the air on market rallies amidst disappointing results

RECENTLY, our stock market was experiencing a rally, which caught a lot of investors by surprise.

As we are now in the reporting season for the companies’ first-quarter financial results, those results that are available thus far show that most companies’ financial performances have indeed slowed down due to the global economic downturn.

Looking at the seemingly contradicting response from the market, how do we relate and explain for the market rally in the midst of the disappointing results from the companies?

If you read the comments from the analysts, you will notice that more often than not, “earnings surprise” is the main reason for the stock prices to increase even though the companies’ result may be down from the previous quarter.

What is an earnings surprise?

An earnings surprise happens when the actual earnings from a company are significantly above or below the market expectation.

Therefore, before an earnings surprise can exist, there must be an earnings expectation from the market. The earnings expectation may be derived from either a simple extrapolation from the historical trend or based on analysts’ forecasts and consensus.

When the earnings expectation for a company is based on historical results, it means that the market is expecting the established income or profit trend for the company or industry in the past to continue into the future.

Therefore, if the actual results happen to deviate significantly from the past trend, it is often being referred to as an earnings reversal or a turning point and, when this happen, it will be called an earnings surprise.

Alternatively, an earnings expectation can be based on consensus from analysts’ forecasts.

Individual analysts will usually use the prior year’s results as a starting point, incorporating any potential impact due to macro-economic or firm-specific factors that they can foresee into the forecasts, to arrive at a more realistic projection of the future.

The market will then gather the forecasts from various analysts, who may be of different views and form a consensus, that smoothen out the impact of divergent views.

When the actual earnings come out to be different from the average forecasts or the consensus, the difference between this two will be the earnings surprise.

Compare with the earlier method, which is a more simplistic method, the earnings expectation based on market consensus is more meaningful as it has included most foreseeable events.

However, this does not mean that the expectations based on analysts’ forecasts are always right.

When there is error in the forecast, and the difference between actual earnings and expected earnings is mainly due to the forecast error, it will not be a surprise to the market and therefore the market will not react to it.

Causes of earnings surprises

An earnings surprise is usually caused by an event that is firm-specific, industry-specific or by an unexpected change in the economic fundamental factor.

Examples of causes include excessive inventory build-ups in inventories and account receivables, emergence of new competitors or competitive products or services in the industry, failure to introduce a new product or services that is much awaited by the market, unexpected changes in the accounting policies or accounting estimates and so forth.

As there are countless possibilities to the causes of earnings surprises, while the analysts may try their very best to use their crystal balls to predict the future, we all know that predicting the future is no easy task.

Thus, more importantly, we need to know how to identify early warning signs or indicators to avoid the surprises.

Market rally versus company performance

Coming back to our initial question, how do we explain the market rally when the companies’ performances are in the red?

As the stock market has already reflected all the good and bad news in the market prior to the companies’ announcements, therefore, even if the results of a particular company are worse off compare with previously, as long as the actual results are consistent with the market expectation, the stock price will not react to the announcement.

If in the event that the actual results come out to be better than expected, even though it is still in the red, it is considered as an earnings surprise and the market will react positively to the announcement.

In our recent market rally, we can see that the results posted by many companies are not as bad as earlier expected, resulting in their stock prices going up.

Of course there are also other external factors, such as expectations that the global financial crisis is coming to an end and the economy is on its way up, are helping to boost the stock market performance.

Ooi Kok Hwa is an investment adviser and managing partner of MRR Consulting