It is very common for analysts to provide forecasts of earnings per share for stocks that they regularly follow. There are also a number of organizations which collect these forecasts together and make them available to investors at large.
Since the price of a given stock is related to its future earnings prospects, one would expect that earnings forecast information could have some value. On the other hand, it is unlikely that a forecast which is a consensus of all analysts has much value since the share price likely already reflects this consensus. The challenge for the investor is to predict when a firm's earnings will deviate from the consensus and to use this information to generate superior returns.
Does superior earnings forecasting pay?
A number of studies of this question have been conducted . One such study by Klemkosky and Miller analyzed 215 stocks from the New York Stock Exchange over the period 1972 to 1981, using the average earnings per share forecasts for each stock published in Standard and Poor's Earnings Forecaster. They found that those stocks for which earnings were underestimated tended to earn a higher return than expected and those for which earnings were overestimated tended to produce a lower than expected return. From this they concluded that a superior earnings forecasting ability could lead to superior returns. These general results have been supported by a number of other studies.
Sources of Superior Earnings Forecasts
Conceivable, superior forecasts of earnings could be generated in a number of ways. First, an individual analyst following a particular stock could have superior insights. Analysts who supply earnings forecasts to clients imply these forecasts are a valuable input to selecting mispriced stocks. Studies of the forecasting ability of analysts have been inconclusive, although the evidence seems to suggest that the consensus forecast may be as accurate a relying consistently on any one analyst.
Another method of obtaining a superior forecast is to utilize the forecasts supplied by the management of the firm. However, these forecasts do not appear to be significantly better than the consensus. A third technique commonly proposed is to forecast earnings employing a mechanical method such as earnings trends or trends in consensus forecasts. For example, Kerrigan noted that if consensus earnings estimates for the year were revised upward in a given quarter they tended to be revised further upward in subsequent periods as well.
