Consensus Estimates: Definition, How They Work, and Examples

Consensus estimates play a crucial role in market analysis, providing investors and analysts with valuable insights into market expectations for key economic indicators such as interest rates, inflation, GDP growth, and stock performance. These forecasts enable the prediction of future economic trends and the assessment of market conditions.

But how exactly are consensus estimates created, how are they used in practice, and what limitations do they have? Dive into this article to find out!

What Are Consensus Estimates, and How Do They Work?

Consensus estimates are forecasts based on collective assessments and predictions from financial analysts regarding future economic performance or market indicators. They serve as a reference point for market expectations on various aspects of the economy, such as GDP growth, interest rates, inflation, and financial results of publicly traded companies.

These estimates are an indispensable tool for investors, financial institutions, and strategic decision-makers, as they allow for evaluating potential market changes and their impact on investments and capital management strategies.

In simpler terms, consensus estimates are the average of forecasts numerous analysts provide. Each analyst formulates predictions based on their own research, macroeconomic analyses, and historical data. These individual forecasts are then aggregated, and the final average becomes the consensus – a prediction averaged from multiple sources. Consensus estimates can be viewed as a benchmark from which the market expects specific results.

Example of inflation consensus estimates for the euro area countries. Source: OECD

For example, before a large company releases its financial report, analysts formulate their predictions about its revenue, net profits, or customer growth. Financial media then publish consensus estimates, which help investors assess whether the financial data aligns with market expectations. If actual results significantly differ from the consensus, it can trigger strong reactions such as stock price increases or decreases.

How Are Consensus Estimates Created?

The process of formulating consensus estimates begins with gathering data from multiple analysts and experts. These predictions may be based on macroeconomic analyses, financial reports, econometric models, and forecasts prepared using historical economic data. After collecting all predictions, extreme values may be eliminated to obtain a more representative figure. Then, an arithmetic mean or median is calculated, representing the consensus estimate.

An important element of this process is eliminating subjective biases. Forecasts that seem overly optimistic or pessimistic may be removed from calculations to ensure the final consensus is as objective and accurate as possible.

Let’s consider a hypothetical scenario of creating a consensus estimate for US GDP growth in the coming year:

• You collect individual forecasts from 50 economists.
• These forecasts range from 1.5% to 3.5% GDP growth.
• After removing outliers, 45 forecasts remain.
• The average of these forecasts is 2.7% GDP growth.
• This 2.7% figure becomes the consensus estimate for US GDP growth.

The chart below, meanwhile, shows consensus estimates for the US GDP according to the Organization for Economic Cooperation and Development (OECD):

GDP estimates for world economies and the US. Source: OECD

Examples of Consensus Estimates

Consensus estimates are widely used in macroeconomic analysis and financial markets. They primarily serve as a tool for predicting outcomes such as:

• Economic growth
• Inflation
• Interest rates
• Various other macroeconomic indicators (e.g., real estate market)
• Future currency exchange rates
• Company financial results

These estimates help investors understand market expectations for a given period, allowing for better planning of investment strategies.

Here are 10 main applications of consensus estimates:

1. Comparing company performance with market expectations
2. Guiding investment decisions and stock valuations
3. Enhancing market efficiency through information aggregation
4. Detecting changes in market sentiment over time
5. Assessing levels of uncertainty in financial forecasts
6. Informing corporate strategic planning processes
7. Providing benchmarks for macroeconomic indicators
8. Mitigating individual analyst biases
9. Measuring the accuracy of financial analysts
10. Assisting in the valuation of financial instruments

Consensus Estimates in Practice

In this section, we discuss three different consensus estimates for interest rates, GDP and inflation.

Interest Rates: Forecasts Before Federal Reserve Meetings

Interest rates are among the most important monetary policy tools, directly impacting financial markets and the economy. Before each Federal Reserve (Fed) meeting, analysts formulate their predictions about whether interest rates will be raised, lowered, or remain unchanged. Consensus estimates then become a collective prediction that serves as a reference point for investors.

• Interest rates in line with consensus: minimal market reaction
• Interest rates below or above consensus: volatility in stock, currency, and bond markets

For instance, Fed surprised markets in September 2033 with a 50 basis point rate cut when the analyst consensus expected only a 25 basis point move. This triggered strong volatility in the dollar and US equities.

Current level of United States Fed Funds. Source: Tradingeconomics.com

GDP Growth: Forecasts in the Context of Economic Crises

Consensus estimates for GDP growth are particularly important during economic crises. Analysts formulate forecasts based on macroeconomic data and analysis of the global situation, allowing for an assessment of the potential effects of recession or economic recovery. In such situations, consensus estimates can serve as an indicator showing market expectations for a country’s economic condition.

An example is the United States during the 2008 financial crisis. Consensus estimates predicted a sharp contraction of the US economy, which significantly influenced decisions made by financial institutions such as the Federal Reserve and the Treasury Department. These forecasts were crucial for determining stimulus packages and negotiating terms for financial sector bailouts.

Inflation and Its Impact on Monetary Policy

Inflation is another indicator where consensus estimates play a vital role. Forecasts about inflation help central banks make decisions regarding monetary policy, especially when setting interest rates. When inflation rises above market expectations, central banks may decide to raise interest rates to curb price growth.

An example of a situation in which inflation surprised analysts is the energy crisis in 2022. A sharp increase in energy and commodity prices caused inflation in many countries to significantly exceed consensus estimates. Inflation reached levels not seen in decades, which forced the Fed to implement a series of more aggressive interest rate hikes than previously assumed. Such deviations from the consensus caused volatility, especially in the bond and currency markets.

Fed was increasing rates to curb inflation and S&P 500 was falling for the entire 2022. Source: Tradingview.com

How Can You Use Consensus Estimates on Your Own?

Try implementing consensus estimates when making decisions related to investing in stock markets:

• Earnings forecasts: The consensus analysts estimate for a company’s future earnings per share (EPS) or total earnings helps investors assess market expectations. Comparing actual results with these estimates can impact stock prices.
• Target prices: The consensus of target prices for stocks (recommendations) provides insight into where analysts collectively believe the stock price may rise in the future.

For example, on October 8, 2024, a new recommendation was issued for Tata Motors, indicating a potential stock growth of nearly 27% based on consensus estimates. The report also projected an increase in revenue and EBITDA over the coming years. Such a report can serve as a basis for a retail investor to make a potential decision to purchase the shares.

Forecasts for Tata Motors earnings. Source: Emkay Research

Limitations of Consensus Estimates

Although consensus estimates are a valuable tool, they have limitations that should be considered:

• Forecast errors
• Market volatility
• Collective bias
• Lack of detail
• Difficulty in comparing
• Overemphasis on past data
• Potentially inflated agreement
• Time lag
• Oversimplification
• Susceptibility to manipulation

Consensus estimates are a key element of market analysis, helping investors and analysts make informed decisions. Despite their limitations, they remain an important part of a retail investor’s broader toolkit. Understanding their role and significance is crucial for effective risk management and maximizing potential investment gains.