Question

What role do financial analysts’ earnings expectations play in the quality of earnings?

Answer 1

Earnings forecasts are based on analysts' expectations of company growth and profitability. To predict earnings, most analysts build financial models that estimate prospective revenues and costs. ... They use market research reports to get a sense of underlying growth trends.

An analyst expectation is a report issued by an individual analyst, investment bank or financial services company indicating how a particular company's stock will perform in the coming quarter. Analysts provide guidance as to how they expect a company to perform. This is typically a range of values that a particular variable is expected to fall between. If a stock performs better than what analysts expected, it is considered to have beaten expectations or delivered stronger-than-expected results; the stock may also have been said to have beat the street. However, if a stock doesn’t perform as well as analysts expected, it is said to have missed estimates. If the stock’s performance varies significantly from most analysts’ expectations, it can be called an earnings surprise, regardless of whether the stock beat or missed estimates.

BREAKING DOWN Analyst Expectation

Publicly traded companies also issue their own guidance outlining expected future profits or losses. This forecast helps financial analysts set expectations, and can be compared to get a better idea of potential company performance in the upcoming quarter.

How Analysts Create Expectation Reports

In order to create an accurate forecast of how a specific company’s stock will perform, an analyst must gather information from several sources. He or she needs to speak with the company’s management, visit that company, study its products and closely watch the industry in which it operates. Then, the analyst will create a mathematical model that incorporates what the analyst has learned and reflects his or her judgment or expectation of that company’s earnings for the forthcoming quarter. The expectations may be published by the company on its website, and will be distributed to the analyst’s clients.

Often, companies want to collaborate with analysts to some extent to help them fine-tune their expectations in order to make them more accurate. Accurate expectations benefit the company, because when a stock misses expectations, share prices can fall. It can benefit the company even more, however, if the analyst’s expectation is low and the company beats it, because this can raise the price of shares. However, sometimes companies might try to use high expectations to drive a stock price up by giving investors the impression that analysts think well of the company.

Consensus Expectation

Usually, multiple analysts will follow the same company and issue their own expectations of that company’s

Key Takeaways

1. A company's real quality of earnings can only be revealed by spotting and removing any anomalies, accounting tricks, or one-time events that skew the numbers.
2. Quality of earnings is the percentage of income that is due to higher sales or lower costs.

performance in the coming quarter. For this reason, most people don’t base their securities purchasing decisions on the expectation of a single analyst, but consider the average of all the expectations issued by the analysts who follow that stock. This average is known as the consensus expectation.

Earnings management. Earnings management, in accounting, is the act of intentionally influencing the process of financial reporting to obtain some private gain. ... Earnings management has a negative effect on earnings quality, and may weaken the credibility of financial reporting.

While managers generally view earnings management as unethical, managers who have worked at companies with cultures characterized by fraudulent financial reporting believe earnings management is more morally right and culturally acceptable than managers who haven't worked in such an environment

A quality of earnings report provides a detailed analysis of all the components of a company's revenue and expenses. ... The primary objective of a quality of earnings report is to assess the sustainability and accuracy of historical earnings as well as the achievability of future projections.

For example, a company may decrease expenses in the current year by refinancing all of its debt into a future balloon payment. This would lower debt expense and increase net income for the current year while pushing the repayment problem down the road.

Calculating earnings quality is completely subjective. Its accuracy depends on the expertise of the person or agency calculating it. We can say that the measure of earning’s quality is the degree to which a company generates earnings from core operations, rather than external forces.

Still, there is a formula to calculate it, and it is dividing the net cash from operating activities by the net income. This formula gives the quality of earnings ratio, rather than the absolute figure.

Quality of earnings ratio = Net cash from operating activities/ Net income

We can get the net cash from operating activities from the cash flow statement, while the net income figure is there in the income statement.

If the ratio is less than one, it means net income is greater than the operating cash flows. This will suggest that the company might be using accounting techniques to inflate net income. On the other hand, if the ratio is greater than one, it would mean net income is less than the operating cash flows, suggesting a better QoE.

FINAL WORDS

For investors, high-quality earnings matter more as a company is more likely to repeat such a performance in the future. This, in turn, would mean more cash flows for investors and high stock prices for the company.1–3