Traders Can’t Afford to Ignore This Metric When Picking Stocks
When picking out targets for a trade, we need to be aware of a number of important issues.
First, of course, we need to choose an underlying stock that has a strong probability of trading higher. We also need to be able to get in at an attractive price. And finally, we need to know how to manage the trade moving forward whether it is moving in our favor or against us.
Today, let’s take a look at an important metric for both choosing the right stock and managing the trade. It gets ignored far too often. We’re talking about analyst expectations, or more importantly, the change in analyst expectations.
Be Aware of Your Competition
As an investor, you need to know what the professionals think about a particular stock. This doesn’t mean that we always agree with them. But institutional investors are heavily influenced by analyst reports. And since their large buy and sell orders are what actually move stock prices, it pays to be aware of their actions.
Whether that’s a good thing or not is a debate for another day. But the good news for you is that you don’t have to be on a hedge fund trading desk to see what analysts expect a company to earn each quarter. Yahoo Finance has a great free tool that allows you to see the average estimates for a particular stock.
We can use this simple tool to determine what analysts are expecting a company to do. And this gives us a better understanding of how institutional traders view the stock.
Change Is More Important Than the Actual Reading
One very important thing to note is the recent changes in analyst opinions. You see, when analysts change their expectations for a company, it is typically because new information is coming out.
That new information could be based on a new product the company is launching. It could be due to a change in demand for the company’s services. Or it could be due to a broad shift in the economy. The key here is that analysts are changing their estimates based on new information. And that new information is very likely to affect how the stock will continue to trade.
If you scroll about halfway down the Yahoo earnings estimates page, you’ll see a section titled “EPS Trends.” We’ve copied a screen shot below for AAPL.
Source: Yahoo Finance
This table allows you to see changes to the average estimate, and when those changes occurred. For example, you can see that analysts increased their estimates for this company gradually over the past 90 days.
While it isn’t necessary to have an increase in analyst expectations, it certainly helps to trade stocks that have an underlying increase in expectations. If analysts are decreasing their expectations, that is a significant red flag. If you are making a short-term trade, then you would need a significant amount of positive data to make up for a decrease in expectations.
A Virtuous Cycle
When considering how high (or low) a stock price can go, you need to look at more than just the analyst expectations. Keep in mind that investors will place a higher or lower value on a stock depending on expectations of growth or contraction.
If a company earns $1 per share and has steady growth, an investor might be willing to pay 10 times earnings, or $10 per share. On the other hand, if a company earns the same $1 per share, but is expected to grow earnings by 40% every year for the next several years, investors will likely be willing to pay 40 times earnings, or $40 per share.
Now, think about what happens when analysts increase their earnings expectations and investors increase their growth assumptions.
You might start with a stock that is expected to earn $1 per share next year, and investors are paying $10 for the stock. They expect the stock to grow modestly, but there isn’t too much excitement around the name. Then, assume the company announces a new product line and analysts increase their expectations to $1.50 per share. At the same time, investors realize that growth will be much stronger, and they may be willing to pay 30 times earnings for this stock.
If you run the math, you’ll realize that the stock is now trading at $45 (30 times the estimate of $1.50). This represents a 350% return — even though estimates only increased by 50%.
Think of this phenomenon as a “virtuous cycle.” It occurs when analyst expectations increase and investors’ growth expectations also increase. With both of these metrics simultaneously working together, stock prices can rally tremendously.
The bottom line: be aware of the analyst estimates for a stock you are researching, but also constantly monitor how those assumptions are changing. This is not only important for traders, but also for growth-oriented investors.
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