Every three months for about six weeks, the stock market goes through a series of fluctuations that are fueled by ecstasy and disappointment.
Investors hover over their computer monitors, watching and listening for cues to enter or leave certain stock positions. Some of them pat themselves on the back for a job well done. Others question whether they should have gone into the family fertilizer business or joined a monastery.
If this sounds like you or someone you know, chances are it’s earning season.
It’s the time every quarter when publicly owned companies release their financial results from the previous quarter. Investors, analysts, and onlookers pay attention to the factors and nuances of all of the results to build their financial strategy and make moves.
Not all of those moves are the right ones or come from the right places, though. We’ll take a look at what the season means and how to read trade earnings reports in the right way.
When Do Earnings Reports Come Out?
After a fiscal quarter concludes — the ends of March, June, September, and December every year — earnings season typically begins a couple of weeks later. So that’s about the middle of April, July, October, and next January, respectively.
Publicly traded companies file their financial results for the previous quarter with the Securities and Exchange Commission (SEC) as the law requires. Many of them then hold a conference call to discuss the reports, talk about the results, and address some of the factors that influenced them. Others simply issue a press release and publish the reports on their corporate websites.
Earnings reports contain all of the relevant information about the company’s most recent financial performance. They include three different financial statements: An income statement, a balance sheet, and a cash flow statement.
Investors look and compare several data points on these sheets, including:
- Net sales, cost of sales, and gross profit margin
- Operating expenses
- Earnings per share
- Capital gains and losses
- Current assets and liabilities
- Shareholders’ equity
- Investing and financing activity
- Tax and interest disclosures
An earnings report may include supplemental information, charts, and tables. They often feature explanations about certain results and may guide the near- and long-term future.
The modern earnings call doubles as PR outreach. Corporate leaders almost always use the conference call to assure investors that business is going well, even if the report is neutral or negative.
Many top companies leave a portion of their presentation open at the end for questions from institutional investors and analysts. This is often viewed as the most pivotal part of the earnings call. It’s when company leadership has to face their stockholders, whose questions may be designed to challenge the companies’ positive PR spin.
How Do Investors React to Earnings Reports?
Is earnings season an important part of the cycle or just an outlet for hype and panic?
Almost every time we address a question structured in that way, the answer is, “a little of both.” This is no exception.
Earnings season is almost always a volatile time for investors. The information they glean from their reports is used to fuel their investment decisions. If a company beats its expectations for the quarter, its success can (but doesn’t always) result in its share prices going up. If it falls short, that can (and almost always does) make the price go down.
In the days and weeks leading up to a company’s earnings report announcement, analysts emerge en masse to offer their opinions and forecasts on what will happen. They come in torrents. Every analyst has their own methods, reasons, and influences for making their opinions. Their information can be either illuminating or confusing.
A huge — perhaps oversized — aspect of earnings season is the focus on results. Did the company beat industry estimates? Did the results meet or beat those of the quarter before? If not, what happened?
Of course, those are all fair questions to ask. And stockholders are certainly entitled to truthful answers about whether a company makes good on its estimates.
But the reaction to that data can be quick and drastic. An overly rosy earnings report may encourage investors to buy in, which drives the share price higher. If speculation gets too optimistic, it could result in the stock becoming overvalued.
Similarly, a depressing earnings report can trigger waves of selling that drive share prices lower. That’s not always warranted because negative earnings aren’t always the result of corporate failure — it could be because of conditions in the overall marketplace or industry.
Even though all of this activity is first spurred by metrics and hard data, it can quickly devolve into emotion-driven investing. Some shareholders may misinterpret or misread a negative earnings report, watch other investors sell off, immediately panic, and trade out of their positions. Or they may panic when they see others buying shares after a strong report if they don’t want to miss the boat.
Unfortunately, although every analyst in the world denounces emotional investing, it’s something that has to be accounted for in future projects, especially during earnings season when investors get worked up.
But enough about them — what about you? How can you know how to trade earnings reports responsibly during the biggest event of every public company’s fiscal quarter?
How to Trade Earnings Reports: Plan Ahead
As with just about anything related to investments, preparation is the key to navigating earnings season.
Make a Watchlist
If you haven’t already done so, make a watchlist of the stocks you hold or are interested in buying. Any online brokerage site or mobile app of value makes it easy to do this. Set your watchlist up to push breaking news notifications to your smartphone or computer. Earnings reports — and the announcement of upcoming earnings reports — are typically handled like breaking news.
Research the Companies
Take a look at your companies’ past earnings reports. Get a general idea of their growth patterns and track record. Note how their business performs during given time frames — some solid companies do better in certain seasons than others. Some are more affected by the market or industry conditions. Look beyond the charts to see if there are understandable factors that may have affected results.
Look at Past Future Guidance
There are three parts of an earnings report that are important to consider in the context of each other:
- Revenue or sales
- Earnings per share (EPS)
- Forward guidance
The importance of looking at revenue and EPS is, hopefully, obvious. But it’s also vital to know whether the company made good on the forward guidance of their historical earnings reports. Repeated quarters of falling short aren’t good omens.
Regard Analysts With Caution
Wall Street analysts can be incredibly helpful at times, but they are noisy and distracting at others. But not all media-friendly, “entertaining” analysts are wrong and not all sober-minded, serious analysts are right. Get to know the analysts before heeding their advice. In the end, the most important analyst is you. Form your forecast based on reliable information.
Set a Plan and Stick to It
When you’ve gotten a grasp on all of the data you’ve researched, form a trading plan that you won’t deviate from. Rule out panic-stricken, emotional investing — but don’t pretend that other traders will do the same.
How to Trade Earnings Reports: Wait
There’s always an elevated risk when you purchase stock shares immediately before the earnings report. That’s mainly because earnings announcements are usually made after the stock market closes. If you buy shares before a report that turns out to be negative, your stock may fall sharply before the next day’s trading and you won’t be able to do anything about it.
Instead, watch how the share price fluctuates throughout the day after the earnings call. You might see an immediate uptick in share price after the conference call, but don’t feel pressured to commit. Wait to see how a positive report impacts the stock price.
Watch trading volume in particular. If the price is going up and the trading volume is high, it indicates that the stock’s getting a lot of institutional investment support, and it might be a good idea to buy. Look for stocks that close in the upper half of their trading range for the day after the announcement.
How to Trade Earnings: Remember that It’s a Roller Coaster
Most of all, keep a clear perspective on the day after the earnings report. The market for your stock will very likely be extremely volatile — much more so than usual.
So don’t let your emotions run ahead of you. If you decide to take a long position, do so with the expectation of sticking with it for a while. If you take a short position or purchase an option to profit or protect yourself from volatility, understand the considerable risk that those vehicles may put you in. Nobody will blame you if you sit the wave out. But if you’re intent on trading after the earnings report, be absolutely sure about your risk tolerance levels.
Most of all, stay on top of news and announcements about your stock. Information is your best ally at all times — but especially during earnings season.