What it means
Analysts working at banks, brokers and independent research firms build financial models of the companies they follow. They publish forecasts for the next few reporting periods, and data providers collect and average them into a consensus.
That consensus is what people mean when they say a company beat or missed expectations. This matters because expectations are already reflected in the share price before results day.
A company can grow profit by 20% and still see its shares fall if analysts had forecast 25%, because the market had already priced in the larger figure. Understanding this is the single most useful thing a non-finance manager can learn about how listed markets react to news.
Companies influence expectations through guidance, meaning their own published forecasts for revenue, margin or capital spending. Management teams have an obvious incentive to set guidance at a level they are confident of exceeding, and analysts adjust their models accordingly, which is why the consensus tends to cluster just under what the company privately expects.
The dispersion of forecasts is as informative as the average. When ten analysts all forecast earnings within two cents of each other, the business is predictable and a surprise will move the price sharply.
When forecasts range widely, the market has little conviction and results day is less of an event. Expectations should be treated as a market benchmark rather than as truth.
Analysts have incomplete information, they update in herds, and their models can be anchored to whatever management last said, so a consensus can be collectively and persistently wrong about a business going through real change.
In practice
Real-world examples.
Example
A software company reports quarterly revenue 2% above consensus but cuts its full-year guidance, and the shares fall 9% the same morning. The market weighs the reduced forward expectation far more heavily than the small historic beat.
Example
A private equity firm preparing to sell a portfolio company studies the analyst consensus for two listed comparators. It uses the forward earnings forecasts, rather than last year's reported figures, to argue for a higher valuation multiple.
Example
A newly listed manufacturer is covered by only two analysts whose forecasts differ by 30%. The chief financial officer begins publishing quarterly guidance specifically to narrow the range and reduce the volatility around results announcements.
Formula
Calculation
Consensus estimate = Sum of individual analyst estimates / Number of analysts
Earnings surprise % = ((Actual result - Consensus estimate) / Consensus estimate) x 100
Five analysts publish full-year earnings per share forecasts for a listed retailer of $1.10, $1.12, $1.15, $1.18 and $1.20. Adding these gives $5.75.
Consensus estimate = $5.75 / 5 = $1.15 per share
The company then reports actual earnings of $1.20 per share.
Earnings surprise % = (($1.20 - $1.15) / $1.15) x 100 = ($0.05 / $1.15) x 100 = 4.3%
A positive surprise of 4.3% is modest but real, and with 40,000,000 shares in issue the five-cent difference represents $2,000,000 of profit above what the market had assumed.Case study
Seen in the real world.
The following is an illustrative and fictional example. Northvale Instruments had been listed for two years and was followed by five analysts. Management prided itself on conservative guidance and had beaten consensus in seven consecutive quarters, usually by three or four cents a share.
In the eighth quarter the company won a large multi-year contract that pulled forward $12,000,000 of revenue. Earnings came in at $1.34 against a consensus of $1.15, a surprise of about 17%, and the shares rose 14% in a day. The problem arrived three months later, when analysts raised their forecasts for the following year on the assumption that the new revenue level would continue.
Northvale's next results were strong in absolute terms but 8% below the newly raised consensus, and the shares gave back everything they had gained. The board's conclusion, recorded in its own review, was that the company had allowed a one-off contract to reset expectations permanently, and it changed its investor communication to separate recurring revenue from contract-driven revenue in every future announcement.
Watch out
Common mistakes.
- Assuming good results always lift the share price. What moves the price is the gap between the result and what the market already expected, not the absolute quality of the numbers.
- Treating the consensus as a precise number. It is an average of a range of views, and the spread around it tells you how confident the market really is.
- Comparing an adjusted company figure with a statutory consensus. Analysts usually forecast on an adjusted basis, so a like-for-like comparison requires checking which definition each side is using.
Questions
People also ask.
What is a whisper number?
It is the informal expectation circulating among traders that can differ from the published consensus, often forming after a company's peers report unexpectedly strong or weak figures.
Are analyst forecasts independent of the company?
Broadly yes, but they are heavily informed by management guidance and by investor meetings, so they rarely stray far from what the company has signalled.
Should a private company care about any of this?
Yes when a sale or funding round is in prospect, because valuation multiples for listed comparators are usually quoted against forecast rather than historic earnings.
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