Traders, this is important: earnings estimate revisions are the most powerful force driving stock prices. This philosophy is based on research conducted Len Zacks, the founder and CEO of Zacks. Earnings estimate revisions are unique in that they serve as an excellent short-term fundamental timing indicator. Rising profit projections suggest a stock is likely to outperform the broader markets over the next one to three months, while falling profit projections suggest a stock is likely to underperform. There are several reasons earnings estimate revisions affect stock prices. With a few tips, you can use them to improve your trading results.

The ABC’s of Earnings
Earnings estimates are simply projections, made by brokerage analysts, of what a company will earn in the future. For example, Zacks receives profit forecasts for thousands of companies and then publishes a consensus estimate for each, which is simply the average of all brokerage analyst forecasts. [The consensus estimates are available free on Zacks.com.]

When a brokerage publishes a new consensus estimate, the firm distributes the new report to clients, both institutional and retail. Institutional clients take this data and enter it into their valuation models. If the earnings estimate changes, then the institutional investor’s opinion on the stock is likely to alter.

For example, assume stock XYZ is trading at $20 and is expected to earn $1 per share in 2008, it has a forward-looking price/earnings ratio (P/E) of 20 ($20/$1 = P/E of 20). Institutional investors’ valuation models calculate this price as being about fair value, meaning they are unlikely to accumulate more shares of the stock. The next day, XYZ introduces a new product and brokerage analysts immediately adjust their 2008 profit forecasts to $1.20 per share. The revised reports are sent to institutional clients who then plug the new profit projections into their valuation models. Suddenly, the stock’s forward P/E is 16.7 ($20/$1.20 = P/E of 16.7), making it appear undervalued. As a result, institutional investors are likely to buy the stock up to $24. (Remember, they think fair value is a P/E of 20, so adjusted forecast of $1.20 x P/E of 20 = target price of $24.) Given the amount of money under management by institutional investors, this change in perceived value is likely to drive the price of the stock higher.

Put another way, say you are looking to buy a smoothie business and don’t want to spend more than $250,000 for it. You find one that is up for sale and hire an appraiser to determine how much the business is really worth. The appraiser looks at the books, analyzes the location and calculates that the business is worth $250,000 or the maximum you would be willing to pay. The next day, you find out a space has become available in a nearby shopping center that is anchored by Lowe’s. You go back to your appraiser and ask him or her how much the business would be worth if you moved it next to the home improvement retailer. Based on the increased level of foot traffic (more people = more smoothies = more profits), the appraiser tells you that the business would be worth $325,000. Does this influence your decision about buying the smoothie business? Of course it does.

Just Like the Big Boys
Institutional investors essentially go through the same process. If brokerage analysts explain to them that XYZ should earn more in the future, then the investors’ attitude toward the stock changes. Institutional investors value companies based on future earning potential. The more money a company is expected to make in the future, the more it is worth. The less money a company is expected to bring in, the less it is worth.

Due to the sheer amount of money under management, institutional investors often accumulate additional shares over a period of several weeks or longer. The reason is that they don’t want to influence trading volume on any one single day and artificially raise their transaction costs. This process allows individual traders to jump in early and benefit from the buying pressure of the larger, institutional investors. As an added bonus, the rise in earnings estimates can tip individuals off to the potential of an upside breakout before the actual move appears on a charting program.

Best of all, a positive revision in earnings estimates can often be followed by upward revisions. The reason is that there is often something positive that is occurring with the company and/or its industry, which in turn is causing analysts to readjust their expectations.

This year, we have seen this occur with Precision Castparts (PCP), currently benefiting from a bullish cycle within the aerospace sector and particularly higher demand for commercial aircraft. Just during the three-month period of May 1 to Aug. 1, fiscal 2008 earnings estimates were revised upward by 20 percent. Correspondingly, the stock appreciated by 32 percent. See Figure 1. Given the company’s propensity to surpass even raised expectations, such a price movement is not out of line.


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It’s the Estimates That Matter
It is important to note that what drives a stock price higher is not brokerage analyst recommendations but rather earnings estimates. A brokerage analyst recommendation is nothing more than a suggestion of what an investor should do with a stock. It can be specific, such as buy or sell, or it can be somewhat vague, such as “sector outperform.” Any change in the recommendation elicits questions from clients. Recommendations also tend to be biased to the positive, partially because of the systematic resistance to the word “sell.” Most important, the benefit to following upgrades is marginal.

Conversely, an earnings estimate is a prediction of what a company will earn in the future. Earnings estimates are influenced by raw material costs, business momentum and company guidance. Because an analyst can justify altering his or her profit outlook by pointing out a change in commodity prices (e.g., oil prices were higher than expected because of a pipeline break), it is comparatively easier to revise a forecast than a recommendation. More important, a recommendation is a suggestion as to what to do with a stock, whereas an earnings estimate determines what a stock should be worth.

Changes in earnings estimates are even more powerful than the actual estimates themselves. The reason is twofold. First, just like most people do not like “sell” recommendations, most don’t like negative earnings surprises either—including CFOs of publicly traded companies. Therefore, brokerage analysts will lower their forecasts ahead of an earnings announcement if they think the company is going to issue a disappointing report—an early signal to get out of a position. Similarly, brokerage analysts have to feel pretty confident about the company’s prospects in order for them to increase their forecasts. In other words, even if the recommendation implies optimism about a company, brokerage analysts are not going to raise their estimates unless they truly believe the company is going to meet (or beat) the elevated expectations. Second, it is the job of brokerage analysts to be experts about the industries and companies they cover. Thus, even when they underestimate what a company is going to earn, they are usually right on the direction of earnings estimates. When the majority (or all) of the covering analysts increase their forecasts, it is usually a sign that something positive is going on—and a sign that the stock price is likely to appreciate.

Getting Started
The best characteristic about earnings estimate revisions is the relative ease by which individual investors can incorporate them into their trading strategies. It is as simple as looking at tables and seeing whether the numbers are getting bigger or smaller, as well as the proportion of how many brokerage analysts are making changes to their estimates. For example, take a look at Figure 2. This shows the trend in earnings estimate revisions for PCP as of Aug. 2, 2007.


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For the current fiscal year (3/2008), nine brokerage analysts provide earnings estimate data. During the past 30 days, eight of the nine covering analysts have increased their profit forecasts. This is important because it suggests that analysts are in agreement that future profits are going to be better than expected. Put another way, if you were to hire nine consultants and eight of them told you things were going to get better (with the ninth not providing an opinion), you would probably be more optimistic. Institutional investors are no different. If multiple brokerage analysts say the profits are going to be higher, then the institutional investors are likely to use the revised numbers in their valuation models and identify the stock as undervalued.

The bottom table in Figure 2 shows the magnitude of the change. Magnitude matters because it provides an idea of how much more optimistic brokerage analysts are. In the case of PCP, the current forecast for this fiscal year (3/2008) is 9.5 percent higher than it was 30 days ago. That is a sizable improvement in forecasts and represents notable optimism.

Monitor Last 30 Days
Active traders with short-term horizons would do well to focus on stocks with positive estimate revisions that have occurred within the past 30 days and, in particular, the last seven. These newer revisions are generally based on the most current information and give traders the best opportunity to jump in ahead of institutional buyers.

Traders who are willing to own a stock for as long as it holds an upward trend should also pay attention to the overall direction of earnings estimate revisions. A stock with multiple positive revisions over the past 60 or 90 days is likely to continue outperforming the market. The reason is that multiple upward revisions are a sign that brokerage analysts are consistently underestimating the companies’—and often the industry’s—strength. As long as revisions continue to be revised upward, traders should consider holding their positions.

There will be instances where a positive revision will indicate buying a stock after it has made a breakout to the upside. This often occurs following a bullish earnings surprise. Traders who are new to using earnings estimate revisions misinterpret the change in the consensus projections as being a lagging indicator, when in fact, the revisions are providing a clear signal that the stock is likely to continue climbing. In other words, the enthusiasm about the positive surprise is just the start of the upward move.

Booking Profits
For example, take a look at Figure 3. We added ENGlobal (ENG) to the Zacks Breakout Trader portfolio on May 22. Although the stock had just risen 13 percent in response to a positive earnings surprise, we were attracted to ENG because of a 10 percent positive revision to full-year earnings estimates. We held the position for 30 days, and then sold the stock for a 15 percent gain after analysts did not alter their forecasts further. By paying attention to earnings estimates, we were able to correctly identify a short-term, upward move in its earliest stages and generate a notable profit for our portfolio.

Moving Ahead
The key point to remember about earnings estimate revisions is that they provide a reason for a stock’s price move over the short-term. A positive change in the consensus estimate will result in a new, higher perceived value for the stock, thereby generating interest among institutional investors. By monitoring earnings estimate revisions, individual investors can identify those stocks likely to benefit from the buying pressure that large institutions create—often before an upside breakout appears on a charting program.