When a stock is upgraded to a Zacks Rank #1 (Strong Buy) or Zacks Rank #2 (Buy), that really means you're seeing the earnings estimates for that stock being upgraded.
And that's important because as earnings estimates go up, so should the price. As earnings estimates rise, so does a stock's perceived 'fair value'. For example, if a stock's EPS estimate was $1.67, and it was trading at 15 times earnings, then fair value for that stock would be $25.00. If estimates increased to $1.73, then anything below $26.00 would be below fair value.
What's also noteworthy is that statistics have shown that stocks receiving upward earnings estimate revisions have a tendency of receiving even more upward earnings revisions. This means once you see a stock with an upgraded EPS estimate, it's time to get on board as there's a good chance you'll see plenty more to drive the estimates and the stock up even further.
Restoration Hardware (RH - Free Report)
On May 3rd, 2013, Restoration Hardware was upgraded from a Zacks Rank #3 (Hold) to a Zacks Rank #2 (Buy). Within five short weeks, their earnings estimates were raised five more times, their Zacks Rank was upgraded yet again to a Zacks Rank #1 (Strong Buy), while their stock soared 46.20% within that same period.
Analysts were not shy about their aggressive upward earnings estimate revisions going into RH's upcoming earnings report. And neither were investors, who couldn't get in quick enough as their confidence rose along with estimates.
On June 13th, 2013, RH rewarded investors with a 50% positive EPS surprise, sending shares up even more.
As good news begets even more good news, analysts revised their outlooks three more times since their surprise, with prices climbing just as fast to keep up with the stock's new fair value. All in all, within 9 weeks of being upgraded to a Zacks Rank #2 (Buy) (and ultimately a #1), RH rallied a whopping 93.35%. Even more impressive was the fact that this was done while the S&P 500 gave up -0.50%, proving that earnings estimate revisions are indeed the most powerful force impacting stock prices.
Why do stocks receiving upward earnings estimate revisions usually receive even more upward revisions? Simply put, analysts tend to change their earnings estimates slowly and incrementally.
Analysts don't typically shoot first and ask questions later. Just the opposite. They analyze their data over and over and over again, and then seem to slowly move in the direction they want to go in.
Revising estimates is not a race. There are three months between each earnings season. But every day is just as important as any other. And each estimate an analyst puts out ties his or her expertise and credibility to it. Analysts get paid for their accuracy, so they will oftentimes contort themselves into knots trying to get it right.
Their pain is an investor's gain, if you know what you're looking at. And the Zacks Rank makes the process of analyzing earnings estimates easy, and as illustrated above, very profitable.
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Disclosure: Performance information for Zacks portfolios and strategies are available at: https://www.zacks.com/performance.