Where Do Earnings Estimates Come From?

The most widely used source of earnings estimates comes from brokerage or "sell-side" analysts. The term "sell-side" refers to the fact that these analysts' employers - brokerage firms, are in the business of trying to get investors to trade stocks. When a broker calls a client, he is trying to use the research produced by his firm's analysts to "sell" the client on trading a stock, thereby generating a commission.

Brokerage analysts typically specialize in a sector or industry, such as software. They are expected to be objective experts for the industries that they cover. However, their earnings forecasts tend to err in being overly conservative because of the influence of corporate executives and pressure from brokerage firm clients, as is explained below.

Company Management:

Public companies create financial projections of their future earnings to properly plan for and manage operations. Corporate executives also use these projections to provide a basis to explain to brokerage analysts how they anticipate their company performing in the future. From there, the analysts will layer in some of their own assumptions in order to create an independent earnings estimate (more on brokerage analysts below).

It is not in the best interest of corporate executives to share the most optimistic projections with brokerage analysts, however. A large percentage of executive compensation comes from company stock and stock option plans. Executives realize that if their company reports earnings that are below analysts' forecasts, almost without exception, the stock price will tumble. This in turn costs them money. Therefore, it is more advantageous for executives to provide brokerage analysts with conservative earnings estimates.

Brokerage Analysts:

The job of a brokerage analyst is to issue buy, sell, and hold stock recommendations on behalf of their employer. Brokerage firms, in turn, use this research to get clients to buy and sell stocks. To justify their recommendations, analysts usually forecast what companies are expected to earn in the future.

Clients will only act on a brokerage analyst's recommendation if they think the recommendation will help them make money. The more money a firm's clients make from a particular analyst's recommendations, the more valuable the analyst is to the firm. Since analysts issue far more "buy" recommendations than "sell" recommendations, they want to avoid making earnings forecasts that are overly optimistic. The incentive for issuing conservative earnings estimates is that the company has a better chance of reporting earnings that exceed forecasts. In turn, clients will be happy to see the stock's price rise. Conversely, there is no incentive to issue an earnings forecast that is overly optimistic.

(Note: Over 10 years ago, only about 50% of companies met or exceeded earnings estimates every quarter. Now that number has moved to 80% as corporate executives and brokerage analysts have wised up to the importance of creating conservative earnings estimates.)

Next: Consensus Estimates

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