Momentum indicators relate to price or a fundamental, such as earnings, to the time series of their past values or the fundamental’s expected value.

There are three major momentum indicators:

• Earnings surprise.
• Standardized unexpected earnings.
• Relative strength.

Earnings Surprise/Unexpected Earnings

Unexpected earnings (also called earnings surprise) are the difference between reported earnings and expected earnings.

$$\text{UE}_{\text{t}}=\text{EPS}_{\text{t}}-\text{E}(\text{EPS}_{\text{t}})$$

Where:

\(\text{UE}_{\text{t}}=\) Unexpected earnings for quarter \(t\).

\(\text{EPS}_{\text{t}}=\) Reported earnings per share for quarter \(t\).

\(\text{E}(\text{EPS}_{\text{t}})=\) Expected EPS for the quarter.

Example: Earnings Surprise/Unexpected Earnings

A stock with reported quarterly earnings of $2.05 and expected earnings of $2.00 would be considered to have a positive earnings surprise of $0.05. The percent earnings surprise would be \(\frac{0.05}{2.00}=0.025\ \text{or}\ 2.5\%\).

Standardized Unexpected Earnings (SUE)

SUE scales unexpected earnings by a measure of the size of historical forecast errors or surprises. The underlying principle is that the lower the historical size of the forecast error, the more meaningful the given forecast error.

It is calculated as:

$$\text{SUE}_{\text{t}}=\frac{\text{EPS}_{t}-\text{E}(\text{EPS}_{\text{t}})}{\sigma[\text{EPS}_{t}-\text{E}(\text{EPS}_{\text{t}})]}$$

Where:

\(\text{EPS}_{t}=\) Actual EPS at time \(t\).

\(\text{E}(\text{EPS}_{\text{t}})=\) Expected EPS at time \(t\).

\(\sigma[\text{EPS}_{t}-\text{E}(\text{EPS}_{\text{t}})]=\) Standard deviation of \(\text{EPS}_{t}-\text{E}(\text{EPS}_{\text{t}})\).

Relative-Strength Indicators

They compare a stock’s performance during a period with its past performance or with the performance of a group of stocks. This indicator is often scaled to 1 in the beginning period for ease of interpretation. If the stock outperforms the index, the relative strength indicator will be greater than 1.

Question

Suppose a stock has reported quarterly earnings of $8.35 and expected earnings of $7.90. The earnings surprise would closest to:

1. 0.45.
2. -0.45.
3. 8.35.

Solution

The correct answer is A.

$$\begin{align*}\text{UE}_{\text{t}}&=\text{EPS}_{\text{t}}-\text{E}(\text{EPS}_{\text{t}})\\&=8.35-7.90\\&=0.45\end{align*}$$

Reading 25: Market-Based Valuation: Price and Enterprise Value Multiples

LOS 25 (p) Describe momentum indicators and their use in valuation.