Expectations and Earnings Surprises

 

In the last few months, a number of doomsayers have hinted that the great bull market of the '90s may be nearing an end. (It should be noted that doomsayers have been predicting imminent financial calamity for the last five years.) In any event, the trigger for calamity this time is to be the volume of "negative earnings surprises."

I like to use earnings forecasts and market reactions to drive home the point that investors look to future, rather than historical, cash flows in making buy/sell decisions. In turn, financial analysis is one of the means by which expectations about future cash flows are formed. Thus, it is possible to make explicit the link between the material in the first third and the second third of Essentials and Fundamentals.

For an interesting exercise, send students to the worldwide web to find out about current earnings surprises. Their first stop should be Yahoo! at http://quote.yahoo.com/. This page contains links to earnings surprise data, as well as debt ratings upgrades and downgrades, IPOs, and up-to-the-minute market news.

Next, have the students check out the day's "extreme surprises" compiled by Zack's Research at www.zacks.com. Although much of the information on this page is accessible only via subscription, it is possible to click on "Surprises" to get this information at no cost.

Now ask the students the following questions.

1. Why are investors surprised when earnings are announced? Don't teams of highly-trained (and highly paid) analysts foresee these things? (The answer to that question is "No way!" according to the December 22 issue of Barron's, in which analysts' skills are skewered.)

2. Exactly how do earnings surprise affect share prices? In other words, can they point to the variables in the constant-growth model and describe how earnings surprises (and the resulting expectations changes) affect each? This forces students to think a little more deeply about what the model really reflects.)

Good luck with this assignment. And have a happy holiday!

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