Rich Dad Stock Blog

When you were in school as a child you received a report card. This report card measured your academic success during the time period in question. Each quarter publicly traded companies issue a quarterly earnings report, which is their version of a report card. This report is designed to let shareholders, as well as potential investors, know how well the company performed over the time period in question.

On this quarterly earnings report, a slew of financial information is released for investors to analyze. Among this information are the earnings per share (EPS), net revenue, and potential changes in guidance for upcoming quarters or fiscal years. While, this quarterly earnings report is not as straightforward as the report cards you received as a child, there are some parallels.

When children bring home their report cards, parents are likely to have certain expectations. One child may receive an A- in math that slightly disappoints parents who had been expecting an A+. Another child’s parents may be delighted with a B when they had been expecting a lower grade. The market’s reaction to company’s earnings reports is very similar. Certain expectations are held by analysts and if those expectations are exceeded, then the market often reacts very favorably. However, if those expectations fall short, then the market’s reaction may be swift and furious.

Market Expectations
The market’s expectations of what a company will report on their earnings report is covered by the term consensus earnings estimate. Analysts are constantly measuring the financial data of a company to attempt to determine the proper valuation for the stock of that company. Because analysts cannot determine the company’s current worth simply by looking in the rear view mirror at past performance, these analysts attempt to determine what the future earnings of the company will be. These forecasts are used to calculate what they feel should be the appropriate current price for the stock. These future estimates are made for future quarters and upcoming fiscal years for the company.

Numerous brokerage firms hire countless analysts to help make these forecasts on what companies will earn in the coming quarters and years. The consensus earnings estimate is normally the average of all of the individual forecasts of analysts covering the stock. A number of separate companies compile this data from individual analysts and the consensus earnings estimate is calculated. When you go to any popular financial website, you will see this consensus number, and whether it has recently been revised upwards or downwards.

Why Consensus Earnings Estimate Matters
There are thousands of publically traded companies and few professional mutual fund managers, let alone your average investor, has time to sift through the financials of every company. The consensus of analysts is used as a type of short-cut for professional and active individual investors to use in making their investing decisions. This does not mean that professional analysts are always correct as they are far from perfect, but in an imperfect world they are viewed by many as the quickest way to accurately determine what future earnings will be and how the company will perform in upcoming years.

The Quarterly Earnings Report
Heading into each quarterly report for a company, the market has their estimate of what that quarterly report will look like. It will have estimates on what the company’s earnings per share and revenue will be. It may look something like this on a financial website:

Company XYZ

Q4 EPS estimate $0.30
Q4 Revenue estimate $741M

When the actual results come out you may see something like this:

Q4 EPS of $0.27 misses by $0.03.
Revenue of $731M (+9% Y/Y) misses by $10M

or

Q4 EPS of $0.35 beats by $0.05.
Revenue of $761M (+9% Y/Y) beats by $20M

These are the raw numbers for that quarter and the results can greatly impact the immediate price of the stock. Most of the time a company will issue their quarterly report before or after normal market hours and you will often see that the stock gaps up or down before the market opens based on the results and reaction to the report. It is well worth noting how the market reacts to the quarterly earnings report is never as simple as whether the company beats its EPS estimate. Analysts and investors often react to what future guidance the company gives for upcoming quarters and years when issuing the report.

For example, if as a parent you were expecting an A- and your child brings home an A+, then you will be excited. If in addition, the child says that based on work already done they are expecting an A+ for the next couple of semesters, then as a parent you are extremely excited. The market behaves similarly, if a company not only exceeds expectations but offers wonderful guidance for the future, then a surge in stock price will likely occur.

On the contrary, if as a parent you were expecting an A+ and your child brings home an A+ but tells you that it looks like they might deliver B work for the coming year, you are going to be disappointed. Remember, the market is always attempting to determine what the future price of the stock will be worth and lowered guidance from companies usually results in at least a short-term price correction.

Earnings and Your Trading
Because of the impact earnings reports can have on the price of a stock, many traders develop rules that prohibit them from holding positions through a company’s earnings report. An at-the-money call bought on a company that misses earnings can quickly become worthless, regardless of whether a stop-loss was put in place. Remember that companies often report their earnings after hours, which can result in the gap in the price of the stock which your stop-loss will not protect. Some traders also use strategies that can maximize the volatility surrounding earnings. The December issue of this eZine covered two of these strategies—straddles and strangles.

Whatever your approach to trading is, you should always be aware of the earnings report date of the stocks you are following. This date can easily be found on numerous financial sites by searching for the company you are interested in. Awareness of this date can help you manage your positions before earnings and help you determine through technical analysis if a new trend is likely to develop as a result of the earnings report.