Meeting Consensus Earnings Forecasts  685 investors understand the drivers of a company’s performance. Our findings demonstrate that when investors are valuing a company, they consider more indicators of financial health than just whether the company meets its consen- sus earnings estimates. Thus, companies need not go to extremes to meet or beat analysts’ expectations if it means damaging the long-term prospects of the company. When Companies Fall Short Most executives haven’t personally experienced many catastrophic drops in share price after minor earnings misses, so they conclude that such misses are rare. The mechanics of earnings estimates lend some support to that percep- tion. After all, analysts’ estimates typically are overly optimistic at the begin- ning of the financial year, but by the third quarter, it’s reasonable to expect them to fall roughly in line with the eventual reported earnings—a pattern borne out by previous research.18 According to standard practice, a company has beaten the consensus estimate if its actual earnings are greater than the last available estimate for the year (almost always projected after the year is over). Consequently, one would expect analyst estimates at that stage to be accurate. Moreover, executives tend to focus on dramatic press accounts of earnings mishaps that are among the most extreme outliers, as in the eBay example where barely missing the consensus forecast led to a sharp drop in share prices. In fact, falling short is common, and the effect is benign. More than 40 percent of companies generate earnings below consensus estimates, whether those estimates are compiled an entire year or just three days before an earn- ings announcement. Although some academics have documented a corre- lation between the change in a company’s share price before and after the announcement of earnings and the degree to which it meets the consensus earnings estimate, the size of the effect is small. Indeed, our analysis suggests that missing the consensus by 1 percent would lead to a share price decrease of only 0.2 percent in the five days after the announcement. In other words, missing the consensus estimate by a penny or so usually doesn’t matter (de- spite the unusual case of eBay). Executives concerned about their company’s performance relative to con- sensus estimates should also consider that 40 percent of companies that saw their earnings miss the consensus estimate also saw their share price, adjusted for the market, move in the opposite direction. For example, when PPG Indus- tries, a global supplier of paints, coatings, and chemicals, announced earnings for 2010 that were 4 percent below the consensus, the market reacted posi- tively with an excess return of 7 percent. Why? On digging deeper, investors 18 M. Goedhart, B. Russell, and Z. Williams, “Prophets and Profits” McKinsey on Finance, no. 2 (Autumn 2001): 11–14. 686  Investor Communications saw that the long-term outlook had improved. Sales were stronger than ex- pected in nearly all business segments. The CEO also announced some invest- ment initiatives that investors viewed as having the potential to create value in the longer term. When Companies Meet or Beat the Consensus Forecast Similarly, meeting or exceeding the consensus estimate is less important than how the earnings were reached. That’s because investors are continually as- sessing other news, such as whether the company met the consensus estimate for revenues as well as earnings. When North American brewing company Molson Coors beat the consensus estimate by 2 percent in 2010, the market nevertheless reacted negatively, with an excess return of –7 percent. Inves- tors saw that the company’s sales volume had declined by 2 percent and that margins also were down; the company beat the consensus only because of a lower-than-expected tax rate. The market reacted to the fundamental drivers of performance—volume and margin—rather than EPS itself. Investors are also able to see through cases where one-off items are respon- sible for meeting the consensus estimate. Meanwhile, earnings announce- ments themselves often include information that helps investors reassess a company’s long-term performance outlook. Our research has shown that the market reaction at the time of an earnings announcement is influenced more by changes in analysts’ expectations for longer-term earnings than by whether the most recent results met the consensus estimate. A company might fall short of current-year earnings estimates and still see its share price increase if analysts revised their earnings estimates upward for the next two years (see Exhibit 34.5). EXHIBIT 34.5  Impact of EPS vs. Earnings Surprise Analysis of 590 announcements of fiscal-year earnings for 2007 by European companies 1.5 2.4 –0.5 –0.6 Median excess return,2 % Lower Higher Companies with positive change in 2-year-forward EPS If changes in 2-year forward EPS1 are positive . . . . . . returns are likelier to be higher . . . Companies with negative change in 2-year-forward EPS Lower Higher Actual EPS vs. consensus estimates2 . . . whether or not consensus estimates are met. 1 Earnings per share. 2 Excess return over market return. 3 Sample size: posititve and lower = 127, positive and higher = 203, negative and lower =118, negative and higher = 142.