Learning how to use earnings estimates can help guide your trading during earnings season. Just be aware of these four caveats.
We are in the heart of Q1 earnings season right now, when publicly traded companies provide guidance on future earnings. This affects everything from valuation to trading strategy during and after earnings season.
Here’s four things to keep in mind when using earnings estimates as part of your analysis.
How to use earnings estimates to guide your trading
Remember these are educated guesses
Not even big investment banks have a crystal ball. Earnings estimates are educated guesses as to how a company is performing now and will be performing in the future. They are based on previous earnings reports, economic trends, industry norms, growth rates, and more. That’s a decent data set to work with.
However, there are many factors that can knock down or enhance an earnings report. “Earnings surprises” come in the form of a global pandemic that forces everyone onto video conference calls for months or overly optimistic views of an entire sector’s future performance.
So don’t rely solely on them
Most traders and investors play close attention to earnings estimates, as it provides one solid data point (see above!) in their overall analysis. But you would never trade or invest only on this data. It’s just one piece of the puzzle.
Meta Platforms has dozens of buy ratings with higher price targets but also a slew of recent upgrades to their earnings prospects. The company will report their latest quarter on Wednesday, April 29 after the close. Will the analysts be right? We’ll find out.
Understand what causes an upside to estimates
Analysts conduct surveys, talk to company management, and attend conferences to gain a general feel for how business is doing.
The semiconductor group has announced a slew of upgrades and revisions to estimates, so their stocks continue to be looked at favorably. Many in this group are hitting new all-time highs, and with 83% of the Nasdaq 100 in the semiconductor sector, the rest of the market relies on its strength to move higher.
Stock prices are based on future performance
The stock market is a forward-looking mechanism. It looks at estimated performance and prices stocks accordingly. Earnings estimates help us make rational sense of current prices, even if they appear to be expensive.
But there’s a huge caveat here. Analysts often choose to give a company a “rosy” outlook on earnings right off the bat, letting the company prove them wrong for being optimistic. That’s dangerous, but it is what Wall Street is paid to do – be bullish.
Of course, a rosy outlook is not always realistic or rational, but if the public buys into it, then the market machine continues to move up and to the right.
So my advice in a nutshell: Look at earnings estimates, but don’t bet the farm on them.
