If you’ve been following the market lately, there is no doubt that you have encountered the term “earnings season.” In this article I will explain what earnings season is, as well as dissect the important terms that accompany this time of year. Additionally, I will examine how analysts and investors react to financial information released during this period, and the way in which stock prices are influenced by these data.
What Is Earnings Season?
Earnings season is the time of the year in which nearly all large publically traded companies issue their earnings reports. Since these reports are released quarterly, earnings season actually occurs four times per year, during the months of January, April, July, and October.
What Is An Earnings Report?
At the end of every quarter, public companies release an earnings report. The purpose of an earnings report is to provide investors, more specifically shareholders, with insight into the performance of a company over the past quarter, a period of about three months. Included in these earnings reports are key stats, such as revenues (total income from business activities), profits (revenues - costs), net sales, earnings per share (EPS), and earnings from continuing operations. These figures allow analysts and investors to compare a company's current performance to Wall Street’s expectations, past results, and future estimates. If companies beat analyst guidance, their success is reflected in higher share prices (although this is not always the case). However, if a company’s results come in below guidance, its stock price tends to get hammered. In plain, earnings reports allow investors to gauge a company's financial health.
How Is Earnings Per Share Calculated; Why Is It Important?
Earnings per share is defined by Investopedia as “the portion of a company’s profit allocated to each outstanding share of common stock.” Earnings per share is calculated by taking net income, subtracting dividends on preferred stock (payments to shareholders, a type of cost), and dividing by average outstanding shares (all of which are reported in an earnings report).
At its core, this equation describes how efficiently companies use their capital in order to generate revenues. Thus, to an extent, EPS indicates a company’s profitability. As an indicator of profitability, EPS is one of the most important components involved in determining a company’s share price. However, EPS is not the only important indicator of company performance. Revenues are also a key determinant of company performance. Generally, revenue reports contain a thorough breakdown of business activities, and are less subjective. This is because companies can manipulate EPS reports by decreasing their “average shares outstanding” (the denominator in the above equation). They do this via stock “buybacks,” in which companies use their cash reserves to repurchase company shares. In doing so, companies reduce their shares outstanding by “internalizing” them (which is completely legal). This is why revenue reports are extremely important. Companies can’t alter these documents without breaking multiple federal laws, thanks to the SEC. As a result, even when EPS beat estimates, stocks will often retreat when revenues are below guidance. Otherwise, so long as EPS and revenues both exceed expectations, stock prices will most likely do the same.
What Role Do Analysts Play During Earnings Season?
For better or worse, analysts are an essential part of earnings season. Using public financial information, in conjunction with economic data and forecast models, analysts estimate a company’s future quarterly (or annual) earnings. Included in these figures are estimated earnings per share (EEPS) and estimated revenue. When a company issues its earnings report, investors compare the actual results to analyst estimates. If a company’s figures exceed analyst expectations, the company is overperforming, and if the numbers are below estimates, the company is underperforming. In most cases, stock prices will increase if they exceed estimates, or drop if they fall short.
Investors Shouldn’t Overreact During Earnings Season
It is important to understand that the change in a company’s stock price, in response to its quarterly earnings report, and analyst estimates, is not necessarily a fair gauge of its overall health. Investors must remember that analyst estimates are simply well-educated guesses, and are by no means an indicator of future expectations. Some of the most successful companies have missed earnings estimates at one time or another, and others routinely miss guidance (but they continue to survive). For some psychological reason, investors struggle to maintain basic investing principles during earnings season, completely dismissing proven long-term strategies. An unusually high amount of trading often occurs in response to earnings announcements, even though stock prices usually recover after these massive selloffs. It's a predictable pattern, fearful investors dump stocks that miss expectations while other investors buy back these shares at what they view to be a discount price (Warren Buffett’s strategy). Likewise, some investors cash out when their company exceeds expectations, while others buy with the confidence that the company will continue to outperform.
I believe that investors should not compulsively buy and sell stocks during earnings season. Instead, they should use the time to evaluate financial data concerning their current holdings, and companies that are of interest to them.