Remember when you were a kid and really wanted a particular gift for Christmas?
Christmas day arrives. Not only do you get what you wished for but you also receive all the accessories that goes with the gift. You are ecstatic that your expectations were exceeded and you feel like your parents are even more special than before.
Believe it or not, this is identical to how the share market operates in determining the price of a company’s shares.
The following information does not take into account your personal objectives, financial situation or needs. You should consider if the relevant investment is appropriate having regard to your own objectives, financial situation and needs.
In the world of investing, the Christmas gift the share market expects from a listed company is simply called consensus or market forecasts. If a company delivers better than consensus forecasts, the market will typically feel the company is a bit more special than before and reward it with a higher share price. The reverse is also true of course.
Consensus Forecasts Explained
Most listed companies (particularly larger ones) have a number of research analysts from prominent investment banks and research firms write reports on the financial prospects of the company. This includes forecasting what they think the company’s future financial performance will be. The consensus or market forecast is simply the average of the financial forecasts provided by these research analysts.
Why are the consensus forecasts so important?
The value of a listed company’s shares are primarily based on the company’s ability to deliver future financial returns to shareholders. Consensus forecasts are vitally important since they are the market’s measure of what financial performance a company is expected to achieve.
How to Use Consensus Forecasts
Here are three proven ways to use consensus forecasts to gain an investment edge.
1. Let’s start with the obvious one. Companies that deliver financial performance exceeding consensus forecasts will usually see their share price start increasing as the market starts to price in even better financial performance in the future. Always be on the lookout for companies that are announcing better financial results (compared to consensus) or those that are guiding research analysts to increase their forecast earnings.
2. Often we are asked how best to judge whether a company has good or bad management. Objectively, the way consensus forecasts vary over time is the best way to judge. For example, the chart below shows Royal Caribbean Cruises’ consensus forecast for 2015 increasing steadily for much of the past 2 years. In other words, management has been delivering more than what consensus forecast was originally expecting. The best management teams can do this consistently year in year out.
3. On the flip side, be extremely wary of companies that deliver financial performance below consensus forecasts (“consensus miss”) or those that guide research analysts to lower consensus forecasts (“consensus downgrade”). From years of experience, misses and downgrades nearly always occur more than once within a short period of time. This is natural because the company usually won’t admit or perhaps don’t initially know the full extent of their own issues. If you see a significant consensus miss or downgrade, always consider selling out before more misses or downgrades come. Here is a recent example in the form of Woolworths:
Where to Find Consensus Forecasts
Summary consensus forecasts for revenue and earnings per share for many Australian and international listed companies are available for free at www.reuters.com/finance/stocks. Beware that some Australian online brokers also provide so called consensus forecasts but really only have 2 or 3 analysts providing data and isn’t really a true measure of market consensus. For the very serious investor, the most detailed breakdown of consensus forecasts is available via a paid Bloomberg subscription.