It’s that time again: For the next month or so, the biggest driver of individual stocks, and the market overall, will be earnings releases. Corporations exist to make money so, understandably enough, how much they make is reflected in their share price. However, understanding earnings isn’t as simple as multiplying profits by a certain number and arriving at a “fair value” price for a stock. Earnings reports, and the market’s reactions to them, are quite complex, and a basic understanding of what they are, what to look for, and how to read the market reaction is essential for anyone investing in the stock market.
What is in an Earnings Report?
Public companies are required to publish a report quarterly that outlines their sales, profits, and other financial data and information that may be relevant to investors. The reports contain an income statement that shows profits or losses from operations, a balance sheet detailing assets and liabilities, and a cash flow statement. It may also include other information, such as commentary on the previous quarter’s performance, any proposed changes to management or the business, and an outlook for future sales and profits that is usually termed "guidance."
What Should I Look for in an Earnings Report? What's Important?
The main elements of a report are revenue and earnings. Earnings are usually expressed as earnings per share, EPS, which shows how much profit the company made on each share. Those are the main elements of an earnings report that you should look for, but they aren’t always the most important.
The only truthful answer is that the most important content in a quarterly earnings report is what the market decides is most important in each case. The sales (usually referred to as revenue because it includes income from things other than just sales), operating costs, and bottom-line profits would logically be the most important factors in the decision making of traders and investors. Growth and profitability during the previous quarter are important but potentially, so are several other things.
Everything is Relative
The stock market reflects the present in some ways, but traders and investors are always looking forward, attempting to predict the future. So, anything in an earnings report that changes the outlook for a company is important. Investors buy stocks that they think will be higher in the future and estimate which ones that may be based on expectations for their earnings to come, rather than just on what the companies did in the past. Analysts on Wall Street are paid to guess how much each company will bring in and how much they will make each quarter. Those guesses are averaged to give a "consensus estimate," also known as the "expected" sales and revenue.
Performance relative to that consensus is the most important influence on stock prices. For example, if a company swings from profit to loss, by all appearances, it would look like a bad quarter. However, if that swing was expected and the loss is less than anticipated, their stock will still rise despite that. The bad news was already priced in, so "not as bad as expected" is good news. Similarly, a company might post record revenues and sales that represent great annual growth, but if they were expected to do even better, the stock will drop. That is why you hear more about a company “beating” or “missing” than about the actual dollar amounts involved.
Why do Stocks Sometimes Jump on "Bad" Earnings and Drop on "Good"?
Even though a company reports a beat based on those estimates, a stock sometimes will drop drastically after a beat, or jump after a miss. There are several reasons for this often-puzzling phenomenon, but usually it is because the earnings have been overshadowed by something else in the report.
Because of the importance of forecasts and expectations in stock pricing, the biggest post-earnings moves are often based on a company’s guidance for the future. Companies aren’t required to give guidance, but when they do, it has a major impact if it is out of line with what had been expected, or with what they previously said. A firm may post a great quarter, but in the report, they may say that they foresee struggles ahead and expect to make less next quarter, or next year. As a result, the stock will fall even on "good" earnings. The opposite can also happen, with strong guidance, we could see a jump on a "bad" earnings report.
There are also a few other things that can cause seemingly illogical post-earnings moves. If traders have all bought a stock expecting good results, then there is always a chance that they will all try to take a profit when the actual report is released, pushing the price down initially on good earnings. Or there may be news in the report that overshadows earnings and even guidance. A successful CEO is retiring, say, or the company has just signed a huge deal with a new customer, or it could be that they are raising or lowering their dividend. It could be almost anything, but earnings aren’t the only thing in an earnings report that moves a stock.
Reacting to Earnings
With all that said, what is the average investor to do? The best advice when it comes to reacting to earnings is to be patient. You will never beat Wall Street when reacting to an earnings report or any other news. Trying that will make it more likely that you miss something that drives the stock in the opposite direction to what may seem logical. Mistakes and errors usually prove expensive. The trick is to understand that the market’s initial reaction is usually based on short-term factors. When they are at odds with the long-term influences, the short-term reaction can provide an opportunity (for example, a company with a bright future dropping on earnings could be a good chance to buy at a discount).
As you watch the flood of earnings over the coming weeks, don’t overreact. Make sure you understand everything in a report before reacting to it and make your decisions based on long-term growth and profitability. If you do that, you will be fine.
*Do you want more articles and analysis like this? If you are familiar with Martin’s work, you will know that he brings a unique perspective to markets and actionable ideas based on that perspective. In addition to writing here, Martin also writes a free newsletter with in-depth analysis and trade ideas focused on just one, long-time underperforming sector that is bouncing fast. To find out more and sign up for the free newsletter, just click here.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
Other Topics
Smart Investing Stocks Investing
Martin Tillier
Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.
Read Martin's Bio