Publicly traded companies are required to report their financial results to regulators and shareholders on a quarterly basis. Earnings season is the dynamic time of year during which most companies state their successes and failures, in the form of these earnings reports.
Earnings report surprises — where profits come in either above or below stock market expectations — can have a significant and instant effect on the stock price of a company. As such, it isn't difficult to understand why executives can go to great lengths to impress Wall Street. Viewed over the longer term, companies listed in the S&P 500 are able to “beat the street” about two-thirds of the time.
Though broadly true that earnings are a key factor in stock performance over time, a negative or positive earnings surprise is not always a reliable indicator of a company’s long term prospects.
Here we take a closer look at the information that is presented to investors during earnings season.
A quarterly report typically includes the following elements:
- unaudited financial statements,
- a discussion of the business conditions that affected financial results,
- guidance as to how the company expects to perform in the following quarters.
Financial statements point to the quarter’s profit or net income, which must be calculated according to Generally Accepted Accounting Principles (GAAP). This typically involves subtracting operating expenses (including depreciation, taxes, and other expenses) from net income.
Earnings per share (EPS) represents the portion of total profit that applies to each outstanding share of company stock. EPS is often the figure that makes headlines, because the financial media tend to focus on whether companies “meet,” “beat,” or “fall short of” the consensus estimate of Wall Street analysts. Using this narrow measuring stick, a company can beat the market by losing less money than expected, or can log billions in profits and still disappoint investors who were counting on more.
Moving the Goalposts
In addition to filing regulatory paperwork, many companies announce their results through press releases, conference calls, and the Internet so they can try to influence how the information is perceived by investors, analysts, and the general public.
To help avoid surprises, many companies take steps to manage the market’s expectations. This may be accomplished by issuing profit warnings or positive revisions to their previous forecasts, which may prompt analysts to adjust their estimates accordingly. Companies may also be able to time certain business moves to help meet quarterly earnings targets.
Earnings figures are watched closely because they represent a corporation’s bottom line, but they also generally reflect past performance. Wall Street tends to be forward looking, so there are other important events that can affect prices over time. Sales performance, research and development, new products, consumer trends, and changing economic conditions can affect a company’s future prospects.
The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost.
The media hype surrounding earnings that come in stronger or weaker than expected can shift attention away from other important details that may be included in a company’s quarterly report. Understanding how the reporting process works may help you keep short-term market swings in perspective.
Rather than obsess over these more emotion-based shifts, a focus on a thoughtful investing strategy based on your financial goals, risk tolerance, and time horizon, will often better serve your investments over the long term.