Predicting forecast errors through joint observation of earnings and revenue forecasts

We propose a simple method to infer the forecast error associated with quarterly estimates of earnings and revenue before the firm announces realized earnings and revenue. The method uses estimates of the profit margin implied by an analyst’s forecasts of both earnings and revenue to identify forecasts that are likely to be optimistic or pessimistic. The ability to anticipate forecast error permits a trading strategy that exploits the average market reaction following positive and negative earnings and revenue surprises.