When a firm reports “better-than-expected” results in its quarterly earnings release, share prices tend to soar. The share price can sometimes climb significantly in a single day, increasing shareholder wealth at an accelerated pace. As a shareholder, one can imagine feeling lucky holding this outperforming stock, fully boosting one’s trust in the firm.
On average 71% of companies listed on the S&P 500 reported “better-than-expected” earnings in 2016. Are these firms truly outperforming expectations, is the analyst expectation consensus biased, or are managers intentionally manipulating the figures?
How Companies Do It
Thomson Reuters analyst David Aurelio provides an S&P earnings dashboard each quarter, showing whether earnings reports are above, match, or below expectations.
The number of listed firms within the S&P 500 index reporting “better-than-expected” earnings varied between 68% and 75% for every quarter of 2016, whereas “lower-than-expected” earnings varied between 16% and 21%.
Analysts Weighing in
An analyst consensus is a combined forecast by analysts following a firm. This consensus is priced into the share price and is unlikely to be biased as they are independent assessors of the company.
A possible explanation can be the pro-forma earnings forecasts by the senior management disclose in conferences where the analysts are present. These pro-forma forecasts are not necessarily conducted according to GAAP methods and are based on numerous assumptions.
This provides a possibility for executives to be cautious in disclosing the estimated future earnings and perhaps present a slightly less attractive report than how the firm is actually doing in reality. At the official earnings announcement date, the firm surprises the markets by reporting “better-than-expected” earnings and the share price is likely to increase.
Another reason that could explain the high amount of firms reporting promising results is earnings management. According to Investopedia, earnings management is defined as “the use of accounting techniques to produce financial reports that present an overly positive view of a company’s business activities and financial position”
Managers’ objective is to maximise shareholder wealth. This can also be the most important requirement for managers receiving their bonuses, which implies that managers will try to find a way to meet expectations and to boost the stock price. According to studies, the positive effect of a single “better-than-expected” report can last for a year. Therefore, managers are intrinsically motivated to be creative in applying accounting rules and principles which will result in overstated earnings. A simple example of doing so can be delaying costs until the next quarter or year or shifting revenues to another period to be able to show steady growth and to report higher earnings in the short term.
Knowing that it is likely that more than 70% of firms have “better-than-expected” results, it may seem like a great opportunity for traders to see high profits in a short amount of time. However, high returns come with high risks. As fast as the stock price can increase after the positive report, it can also decrease at the same or a faster pace when there is a negative surprise.
Although a firm might be, in fact, financially healthy and growing, it is still more likely it will try to maximise shareholder wealth by intentionally forecasting cautiously in the pro-forma earnings releases and/or make use of earnings management for the official report.