Company earnings are watched closely by analysts. These analysts generally publish ‘estimates’ or ‘expectations’ for the earnings of the companies they analyse. These expectations are ‘priced in’ or reflected by the company’s share price rather quickly.
Share prices are established based on the collective expectations of investors for the future earnings of the firm. Stock prices therefore adjust as these expectations change. When a company’s earnings are announced (quarterly or annually), and the result exceeds analysts’ estimates, this is described as a positive earnings surprise. This usually leads to an increase in the share price of the company as it is adjusts itself to reflect improved expectations for the prospects of the company.
When a company’s reported earnings are below analysts’ estimates, the result is a negative earnings surprise. This usually leads to a decrease in the share price of the company, which needs to be adjusted to reflect the reduced prospects for future earnings.