A strong, direct relation exists between unexpected earnings changes and share price fluctuations. Actual and unexpected earnings changes explain up to 20 per cent of the variation in individual security returns. Furthermore, regressions of annual stock returns against forecast errors and against actual earnings indicate that firms that experience relatively high return performance are characterized by both substantial increases in earnings and by earnings that surpass the expectations of professional analysts.
An examination of analysts’ revisions of their forecasts indicates that forecasts for the eventual top-performing firms become more optimistic as time passes, while forecasts for the worst firms become more pessimistic. Earnings announcements (either favorable or unfavorable) appear to be the primary stimuli behind major forecast revisions.
Securities that are the subject of significant revisions (a 5 per cent or more change) tend to experience significant excess returns over the remainder of the year. This suggests that investors may improve their performance by immediately purchasing stocks that have experienced an upward revision in the consensus forecast and selling stocks for which the consensus forecast has been revised downward.
