Unexpected Earnings

Mainly utilized in accounting to address the difference between an organization's actual earnings for a period

"Unexpected earnings" is the term mainly utilized in accounting to address the difference between an organization's actual earnings for a period and the earnings that they were supposed to generate. It is also known as an "earnings surprise."

Unexpected Earnings

Meaning of unexpected earning

The "unexpected" aspect can be either positive, which means that the organization generated more earnings than expected, or negative, which means that the organization earned less than predicted or expected.

Even with meticulous planning, there is always a chance that the unexpected will happen, leading to a firm or investment producing earnings significantly below what was anticipated. After all, a corporate organization's primary goal is to make money.

It would be perfect if the earnings figure is greater than the expected amount, but there is also the possibility of it being less than the expected earnings. So earning more than expected or thought would always be a welcome surprise.

But if it is the other way around, where the actual earnings are much less than expected, then that is extremely unfortunate. This is an obvious sign that the business firm or investment has underperformed or failed to meet its expectations.

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Receiving this earning is a fantastic feeling, whether in the form of a bonus at the workplace, a tax refund, a birthday, or a graduation check. Your mind will be quickly swept up with all the fabulous ways you could enjoy it.

Understanding unexpected earnings

Financial analysts employ specific strategies to predict the earnings a company or investment should generate. Every period, analysts use methods to predict the expected gains or returns of a business or investment.

They base these predictions on certain factors such as previous financial reports, current market conditions, and business or investment economic behavior theory. These forecasts are not made out of thin air, so investors depend on them.

While analysts often understand or know what they are doing, forecasting earnings or stock prices can get tricky. Sometimes, even with their many techniques, they can still make inaccurate predictions.

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How do you calculate unexpected earnings?

Subtract consensus earnings from the actual reported earnings, then divide the result by the consensus earnings estimate to arrive at the unexpected earnings as a percentage.

It can either be positive or negative. A positive earnings surprise indicates that the business has outperformed the expectations or beaten its earnings estimate. Conversely, a negative earnings surprise suggests that the company has underperformed the expectations set by the earnings estimates.

A breadth of earnings estimates from individual analysts is used to create a consensus earnings estimate. Once a firm releases its quarterly or annual earnings report, those numbers will be compared with the earnings estimate.

Assuming that earnings are considerably higher or lower than expected, the result is an earnings surprise.

For example, for the fiscal quarter ending September 2020, Apple Inc. (AAPL) reported a 20.19% earnings surprise. This implies that the company's quarterly earnings beat estimates by 20.19%.

Standardized Unexpected Earnings (SUE)

This is one of the most common methods used to measure or determine it. It is performed using a formula to determine "standardized unexpected earnings" or SUE.

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These earnings are often used while building strategies for trading. However, in order to examine if such a strategy is effective, the relationship between the performance of a firm's stock and its earnings (unexpected) must be explored.

This can be done with the SUE formula:

SUE = [EPS(Q1) - fEPS(Q2)]  / SD(Q1)

Where,

  • EPS(Q1) - shows that the earnings per share reported for a given quarter

  • fEPS(Q1) - the predicted or anticipated earnings per share of a firm during the same quarter.

  • SD(Q1) - the Standard Deviation of the estimated earnings for the specified quarter.

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The SUE equation enables a trader or analyst to understand where the stock's current price falls. It shows whether it is inside a single standard deviation of the expected cost or not.

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Analysts examine estimated earnings per share through various mathematical prediction methods and financial models to express, based on historical data, what the company should reasonably be expected to earn during a given time.

Difference between expected and unexpected earnings 

There are some fundamental differences between expected and unexpected earnings that are important to know:

 
Expected EarningsUnexpected Earnings
Expected earnings are the earnings a business is forecasted to generate. It generates profits that are significantly different from what was expected.
The figure is determined by market analysts who study the firm's historical earnings. It is determined by differentiating between a business entity's reported earnings and expected earnings.
The expected earnings should be reasonable, which means that the business can confidently generate them for the upcoming period. It does not need to be reasonable. This means that the business can generate profits as much as it can.

 

Apart from the previously mentioned differences between expected and unexpected earnings, there is a handful more:

Expected earnings are calculated using models, allowing analysts to predict what the company will reasonably generate during the upcoming accounting period. Still, unexpected earnings are only known once the period has passed.

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There are no unexpected earnings without expected earnings, so it is essential to understand how analysts "expect" earnings. Expected earnings are reasonable.

Earnings surprises and analyst estimates

Before firms release their quarterly or yearly results, analysts spend significant time attempting to forecast earnings per share (EPS) and other metrics. Many analysts derive an EPS estimate from forecasting models, management advice, and other essential data.

Analysts rely on various fundamental elements contained in companies' SEC filings (e.g., SEC form 10-Q for a quarterly report and SEC form 10-K for its more comprehensive annual report).

In both reports, the management discussion and analysis (MD&A) section gives a detailed overview of the previous period's operations, how the organization performed financially, and how management plans to move forward in the upcoming reporting period.

In its discussion and analysis, management delves into the precise causes of the many parts of corporate growth or decline, as shown on the income statement, balance sheet, and cash flow statement.

Management also frequently utilizes the MD&A section to announce upcoming objectives, ways to deal with new projects, and any changes in the executive suite and/or critical hires.

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Analysts want to wipe out "unexpected" profit as much as reasonably possible because it implies that their work is precise and accurate.

Breakdown of earnings surprises

An analyst must gather information from specific sources to determine how a particular company's stock will perform. They need to speak with the organization's management, visit the organization, concentrate on its items, and intently watch the industries in which it works.

Later, the analyst will create a quantitative model that incorporates what the analyst has learned and reflects their judgment or expectations about that company's earnings for the upcoming quarter.

The organization that employs the analyst may disclose the assumptions on its website and/or communicate them to the clients of the analyst. When a corporation releases figures that are different from these projections, it comes as a surprise.

Earnings surprises can have a significant impact on a company's stock price. According to several studies, favorable earnings surprises result in an immediate boost in the stock price and a long-term rise.

Thus, it is not surprising that few businesses have a reputation for consistently exceeding earnings forecasts.

On the other hand, the share price will typically drop in the event of a negative earnings surprise.

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Note:

A publicly-traded company may also issue its guidance outlining predicted future profits or losses. This prediction helps financial analysts set their expectations and compare better to understand potential company performance in the upcoming quarter.

How does an earnings surprise work?

Stock market analysts study different information and financial data to develop an accurate earnings estimate. Analysts are trying to estimate the company's earnings per share (EPS) reported in the upcoming filings.

Earnings per share is an organization's net profit divided by the number of outstanding shares. In simple words, EPS describes how much money a business makes for each share of stock it has issued.

When a firm has a higher EPS, it indicates that the firm may be undervalued. This can attract investors and the market as a whole.

Understanding earnings surprises is essential if you own equities for one particular straightforward purpose, making a profit. A company's stock price may be affected by whether or not its profit estimates are met or exceeded.

Investors may purchase the stock when a company outperforms its estimated profits and experiences a mild earnings surprise. As more traders buy shares, the stock price will likely increase.

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Any shares you own could be worth more, and you could potentially sell them for a significant profit. On the other hand, a negative earnings surprise could bring stock prices down. If the investor sentiment towards the company turns negative, you might observe a sell-off.

The more shares sold, the more the stock's price could drop. So, in that case, if you own shares, you might lose money.

Both significantly impact stock prices and trading activity, whether unexpected earnings are positive or negative. This is important to understand if you hold stocks in your portfolio.

Considering the bigger picture is essential because one poor quarter doesn't necessarily show a company underperforming. Coinbase is the best example of a company with positive and negative earnings surprises in 2021.

Instead of concentrating on a single earnings report, you can benefit from a deeper understanding of a company's financial health by looking at its essential characteristics.

Note: 

Earnings surprises can also occur at the sector level if an entire market segment beats or misses analyst projections.

Causes and effects 

It is easier to predict if any newsworthy events are related to the firm. In addition, these events offer essential insights into future direction.

For example, an activity that causes a public embarrassment will adversely influence a business' planned income, prompting a negative earning surprise.

Surprise

These earnings may also result from external factors, such as a change in the economic climate. For example, the recent global pandemic caused a stir in the financial world.

It had a negative financial impact on some firms. They most likely made less money than they anticipated. Analysts typically aim to reduce "unexpected" earnings as much as possible to produce precise estimates.

An event pattern known as a "negative earnings surprise" occurs when a company releases earnings data that the market interprets as worse than anticipated.

A poor earnings surprise is typically nothing to be concerned about as long as the stock does not experience a significant intraday movement.

Impact on the valuation of stocks

Examining the value of a stock in the public market is a combination of science and art. Analysts will get paid hundreds of thousands of dollars annually to follow stores and determine and predict their value.

They usually do this using several standard methods, with discounted free cash flow valuations being the most common. Alongside these valuations are market trading factors and economic influences, which can simultaneously affect market values.

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Generally, there might be several reasons why a stock would fall with earnings surprises. Standard valuation methodologies and analyst ratings are usually a part of the science, but other factors can also make up the art.

Publicly-traded organizations are required by the Securities and Exchange Commission SEC to report earnings results quarterly publicly (four times a year).

While this provides a lot of transparency, it can also lead to rumors building up as there is a three-month gap between each release.

Moreover, any substantial discrepancies in expectations will also influence and have a significant impact on the stock's price.

Surprise

Importance of unexpected earnings

Because of their potential importance for investors, it is crucial in the accounting and financial sectors.

Because of the "surprising" nature of the earnings, a stock's price may sharply increase or decrease in a single day.

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Researched and authored by Spoorti Biradar | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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