On The Nuances of Using Earnings Reports to Make Trading Decisions

We dive deep into the details around how earnings reports will affect a company's stock price and what it means for your trading strategy.

August 22, 2020 • By Joel Aduba

Introduction

We’re going to take a holistic view at the nuances of making trading decisions based on information provided by publicly traded companies in their Quarterly Earnings Reports and Calls.

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“Fear incites human action far more urgently than does the impressive weight of historical evidence” - Jeremy Siegel

Definitions

Earnings reports can be thought of as the quarterly report card of any given publicly traded company during the fiscal year. Similarly earning calls can be thought of as the parent-teacher conferences in which companies are given the opportunity to either explain their shortcomings and justify strategic decisions made in a quarter or brag to parents (stockholders, investors, employees, and clients) about what went well and how bright the future is with new potential partnerships being formed or strategies being undertaken. These two terms are founded in the Earnings Per Share (EPS) of a given security which is the company’s profit divided by the outstanding shares of its common stock. The higher a company’s EPS, the more profitable its stocks are considered. Reports can be issued in all manner of time frames, but for the layman trader quarterly and annual earnings reports tend to be most pertinent.


Indication & Direction

Among the attendees of earnings calls (typically held as webcasts or virtual calls) are employees, stockholders, corporate partners and clients as well as professional trading analysts. Given such a wide, large and varied audience it is an understatement to say that earnings calls and their accompanying “seasons” are important periods in any given corporation’s fiscal year.

Simply put, when a company meets the revenue and growth expectations established by market analysts and stockholders, its stock price is rewarded with an increased valuation and consequent price hike on the stock exchange. This price action can typically be understood to be from investors seeing positive indicators of a healthy security and therefore rushing to acquire more and more stocks. This increase in trading volume pushes the value further and further in addition to valuations by analysts that pay attention to the stock. Similarly, if a company fails to meet expectations its stock price may decrease. The more significant the gap between expectations and achievement, the greater the price increase. Sometimes this may even mean that in a particularly difficult fiscal year, wherein a stock has experienced continued price decline as a result of circumstances somewhat outside the company’s control (as in the case of a deep economic recession for example) targets may even include the mitigation of losses as opposed to sustained growth. This is an important distinction to make to avoid oversimplifying how earning reports affect stock prices.

Just because a company reports positive revenue and growth does not mean its price will always increase. For example take a company that in a prior year announces that it expects a CAGR (compound annual growth rate) of 30% and leads analysts to forecast as much and it only achieves 15%. Overall it did in fact experience positive growth but only met half of its goal, therefore the stock market might reflect a price stagnation if not a decrease as a result of the company far overestimating its capabilities.


Market Expectations

As anyone who’s ever been to school will tell you, grades are informative. More than for ranking an individual and comparisons to competitors and peers, evaluated performance at the end of a semester (herein a fiscal quarter) can inform a student as to whether a given set of strategies or techniques have been successful and therefore warrant continuation, or if a correction of course is needed. More importantly to investors, quarterly earnings reports provide market glimpses at how a stock will be priced in the near future. Market expectations are often set by those paying attention to the field or industry in which a company finds itself, namely stock brokers and security analysts (think financial new agencies like Bloomberg, Institutions like Goldman Sachs, and your run-of-the-mill venture capital firms). These expectations include specific forecasts on EPS estimates, predicted quarterly revenue, loses, hiring and retention numbers, even taxation deficits. The latter two tend to be anticipated by on lookers on an annual basis as opposed to quarterly. When cohesively predicted based on market volatility and the specific business strategies of a company to expand or sustain success, these facets lend analysts the ability to build a fairly reliable prediction of how it will perform in any given time frame and how the market will reflect this creation (or loss) of value.

Analyst Forecasts and the Consensus

As in all areas of securities trading, there is a symbiotic relationship between perception of a stock’s health and its actual performance. The more obvious side of this of course is that if a company has a historically profitable performance analysts come to a conclusion that it will continue to be so in an upcoming quarter or fiscal year. The less explicit and less understood effect is how such positive outlooks can preemptively cause a stock to rise in price in the days before earnings are even announced.

Aside from word-of-mouth and insider knowledge, analysts themselves use a bevy of technical tools and presumably their own financial education and experience to quantify the predicted growth or shortcomings of a security preceding and following earnings reports. This community of technical experts use the reports on revenues and costs outlined by those at the helms of corporations to come up with EPS estimates. In this community consensus is important given the wide variety of opinions, analysis techniques and experiences applied to make conclusive and accurate estimates of how a stock will perform. That is why many trading platforms’ “analysis panels” feature the opinions and writings of analysts of a varied set of verifiable technical backgrounds. What one person sees as a potential opportunity to expand may be seen by another as a distraction from a successful, proven strategy. In their best forms analysts’ estimates stem from detail-oriented study and specialised techniques. In their worst forms they boil down to little more than educated guesses. Therefore it is important when evaluating via earning reports, whether a company has met or beat expectations, to look for overlap in analytic predictions rather than outliers.

Analysts more than anyone understand just how involved companies can be in crafting the image they want to present to investors and stakeholders. Therefore it is important to look into professional interpretations of the ample information presented via earnings calls. After all the old adage “perception is reality” isn’t more true anywhere than in securities trading.

The Art of Impressions and Estimates

As much as analysis of a company’s performance by outside observers can affect a stock’s price, what the company chooses to report on in the first instance has the most undervalued effect. Governmental agencies like the SEC in the United States and ESMA in Europe provide guidelines and oversight for the bare minimum content standards of earnings reports. They provide the guard rails to hold companies accountable to stockholders, investors and employees by providing mechanisms for accountability and investor protection from harmful business practices.

However, it is worth remembering that no company wants to report bad news as no stakeholder wants to receive bad news. Therefore there exist a multitude of loopholes for companies to paint as incomplete a picture as possible to maintain perceived profitability and therefore keep stockholders happy. Investors often forget that companies do “manage” their targets so as to hit analyst predictions resulting in increased stock market valuation. For example the top management of a company can far underestimate its predicted unit sales of a product — thereby underestimating predicted revenue — well aware that in a coming quarter they could easily exceed that prediction. On the other side of this coin is the manipulation of time frames. At the micro-level a company can have workers and managers delay expense reports. Downstream, this amounts to postponing the deficit business costs may have on net profits for a quarter. This gives the impression that a particular quarter brought in a great deal of revenue while keeping costs low. This is why in publicly available expense reports it is important to pay close attention to fixed operating costs. If operating costs remain the same year-in-year out, yet somehow profits steadily increase without the price of the product/service offered by the company going up or management providing some sort of explanation for different business strategies employed, suspicion is a safe bet. In short, numbers manipulation happens . This is why in addition to actually reading earnings reports when publically available, matching numbers to the impressions made by the C-suite in calls is important, to ensure in essence you as an investor are not getting hoodwinked.

This isn’t to say that companies lie in their earnings reports. Making factually incorrect statements or questionable assumptions to mislead can create doubt in the minds of investors when discovered and even go so far as inviting litigation by an oversight agency like the SEC [see Elon Musk tanking Tesla stocks with a single tweet and being hounded by said agency].

It is also worth noting that given “Black Swan” events — rare unpredictable events such as pandemics, or large-cale occurrences with widespread severe or catastrophic outcomes — earnings reports are an opportunity to provide ease to or face reality with investors. At the start of the current era of the COVID-19 pandemic for example, many companies initially saw their stock prices sink as analysts forecasted decreased productivity and overall profitability. So one would have presumably expected quarterly earning reports to be bleak affairs — melancholy gatherings full of anxiety and nervous backtracking from prior hopeful targets. However the most innovative companies, despite whether they saw imminnect rebounds in their cards or not, instead used earnings calls to focus on avenues of potential recovery.

Granted, there must be potential ways to recoup losses for this to be the case. Afterall to make good decisions, there must firstly be ample good choices. One thing companies can focus on is partnerships with others in their or adjacent spaces and industries. For example if the terms of a partnership are not yet finalized, but the company is struggling to find good news to relay to investors , management may choose to preemptively announce a potential partnership or on-going acquisition talks. Again, this creates the impression of adaptation and innovation. Whether this is actually the case or not is down to the investors own research and knowledge. However it is easy to conclude that if a company is partnering with another publicly traded institution or company with historically strong performance, their fates become interlocked in a sense. Similar to how stock prices rise or fall with announced acquisitions, earnings calls are oftentimes the first time companies announce the details of their corporate partnerships. Thus in an era where knowledge is arguably the most valuable commodity, early access to it often translates to early profits when it comes to stock acquisition.




Conclusion

In conclusion, things are hardly ever black or white. It is incredibly prudent to look for nuances when using earnings reports to make trading decisions. A couple things to keep in mind to do so effectively are to :

  • Look for a varied selection of opinions from trading analysts, generally the more you have the more complete an outlook you’ll have;
  • Take CEO’s and presenting managements’ proclamations and self-assessments at face value during calls, but keep in mind that companies will paint the rosiet picture possible;
  • Read the earnings reports as documents in their own right to make sure you are not being misled, particularly in the context of their stock’s historical performance;
  • And most importantly: question why you are invested in a given security.

If you are holding stocks in a particular company as a longer-term investment short-term negative changes might be worth ignoring. However if you trade frequently in high volumes, long-term decisions outlined in earnings reports such as change of C-suite management, product pricing restructuring, or new partnerships might make you reconsider or buttress a decision to acquire more stock. In this pursuit use caution, discernment and in the words of Robert Frost search for the “road less-travelled”.




Disclaimer

DO NOT BASE ANY INVESTMENT DECISION UPON ANY MATERIALS FOUND ON THIS WEBSITE. We are not registered as a securities broker-dealer or an investment adviser either with the U.S. Securities and Exchange Commission (the “SEC”) or with any state securities regulatory authority. We are neither licensed nor qualified to provide investment advice.

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