Analysts strive to come up with an estimate of what companies will do in the future, based on expectations, models, subjective assessments, market sentiment, and empirical research. Consensus estimates, made up of many individual analyst assessments, are often more art than an exact science. Each analyst's research relies not only on financial statements (i.e. the company's balance sheet, income statement, or cash flow statement), but also on their individual personal input to the analysis and the subsequent interpretation of the results.
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Analysts often use inputs from the aforementioned data sources and put them into a discounted cash flow (DCF) model. Discounted Cash Flow Cash flow is a method of valuation, which uses forecasts of future free cash flow (FCF) and discounted them, using the required annual rate, to arrive at an estimate of the present value.
If the present value reached is higher than the current market price of a stock, the analyst may come up with a "higher" consensus. In contrast, if the present value of future cash flows is less than the share price at the time of calculation, the analyst may conclude that the stock is priced "below" consensus.
Consensus estimates and market efficiency (in)
All of this leads some critics to believe that the market is not as efficient as is often claimed, and that efficiency is driven by estimates about many future events that may not be accurate. This may help explain why the company's stock is quickly adjusted with new information, provided by the quarterly earnings and revenue numbers, when these numbers differ from the agreed estimate.
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A 2013 study by consulting firm McKinsey found that lack of consensus estimates has no material effect on the company's stock price. "In the short term, the failure to meet earnings estimates is rarely catastrophic," the study authors wrote.
Their analysis found that losing a consensus of 1% causes the share price to drop by only a tenth of percent in the five-day period following the announcement. But the study also cautioned against over-reading the results. According to their authors, the consensus estimates "hint" at investor concerns about a particular company or sector.
For example, let's take a look at Molson Coors Brewing Company (TAP). In 2010, the beverage maker exceeded consensus estimates by 2%. However, its shares continued to decline 7 per cent as investors attributed the profit surprise to a one-time tax credit, rather than an improvement in the company's core strategy and long-term profitability.[/size]