One such thing is earnings revision. When a company, or analyst makes an earnings revision, they generally have a fundamental reason why. Perhaps they estimate that something they plan to do will have a very positive effect. If the general consensus was that the earnings estimate was accurate before, and suddenly new data projects it higher, and the general consensus is that this is accurate, the stock should in theory instantly be priced higher according to the revision. However, who is going to make an investment blindly based upon a revision without looking into it themselves? The same thing occurs when earnings are beat and suprise as they report numbers that are above consensus, the stock should rise in value instantly according to effecient market theory. However both of these do not seem to occur.
If you are able to buy a stock at the same price instantly after higher revisions have been made, and you believe the stock to be of good value before hand, you should almost always buy it immediately and figure out the projections later.
Let me explain why this is. There are several ways to value a company. Some people like to look at book value, others look at earnings, other’s look at the projected future earnings, others look at projected future book value.
Lets say a company has 0 earnings growth. It has EPS of $5 per share and is expected to continue to produce at $5 per share. If you price a stock at 10 years worth of earnings, and you assume this is accurate and a predictable business, you can say it should earn $5 per share for 10 years and accumulate $50 per share worth of earnings over the next 10 years. Therefore, if the company is currently priced at book value and is worth $25 per share, you might say the company should be valued at 10 years worth of earnings, or $50 per share. If it takes 10 years for the stock to reach that level, you will yield 20% per year if earnings stay constant. Even if it takes longer than 10 years, the earnings will continue to come in, and at some point, the stock should reach fair value, and yield 20% per year.
Now what if all of a sudden analysts as well as the company itself all came out and said they had projects under way and expect overall to have long term earnings per share growth of 20%? You could consider that a 20% increase from $5 per share would be $6 per share. A 20% increase from $6 per share would be $7.2 per share and so on. If you project this forward for 10 years total now it’s valued at $130! Quite the big difference! Now you’re looking at a per year return of about 52% as opposed to 20%.
That’s assuming that earnings goes up 20% per year every single year. If growth continues beyond 10 years, your return is actually better as a percentage increase every year results in an exponential effect on the price of the stock. That won’t always happen, especially in unpredictable companies with unstable businesses. Dot com stocks bombed out because of unstable earnings expectency never came.
Additionally, if a company is managed well, it’s possible that the earnings growth will continue to increase as time goes on. This results in accelerated earnings growth. A rare thing, but seen in stocks like Apple. An upwards revision is an early sign of potential earnings acceleration as well.
Hopefully you can see the power of earnings revision and why it can be so powerful. Independently, Zacks.com has compiled some interesting research on earnings revision and they believe that earnings revisions is the most powerful indicator on how a stock will perform. You can read about the Zacks philosophy here.
If you take the Buffett method of projecting future earnings to analyze the value of a stock combined with the power of upwards revisions, you can get a stock that suddenly yields much higher due to upwards revisions. This won’t always be reflected in the price immediately. However, stablility and predictability in the business is important because it’s possible that the projections are simply difficult to make due to uncertainty in that specific business. Regardless, any earnings estimate upwards revision should generally increase the stocks value. If the stock was effeciently priced before, and new data becomes available suggesting it should go higher, and it doesn’t go up immediately, it’s only a matter of time before it does, assuming the earnings revisor has any credibility at all in the eyes of any potential investor at all.
Trading earnings revisions can be profitable, but using them to invest in companies that already seem like good buys before the revision can also be a very good decision.
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