Earnings rank as one of the most important fundamental elements that determine a company’s stock price. The earnings of a company refers to its after-tax net income, which can give you a good indication of the company’s future profitability.
A company’s earnings numbers depict its profitability over a certain period of time, typically a year or a quarterly 3-month period. Most analysts use quarterly earnings as a benchmark to assess a company’s performance.
The deviation of earnings from the analyst consensus, also known as the “earnings call,” can have a notable impact on a company’s stock price. The release of better-than-expected earnings numbers should prompt a rally in a stock’s price but the price can sometimes decline as market participants take profits.
What is an Earnings Calendar?
An earnings calendar shows the date and time of upcoming financial results of public companies. Analysts, traders and investors keep track of earnings releases by using an earnings calendar. Earnings calendars help traders and investors track the financial performance of the companies and make investment decisions.
The earnings calendar typically also gives market consensus estimates. Analysts, traders and investors can use this data to make or compare their own projections. It also helps market participants plan their strategies for the earnings release date in advance.
How Are Earnings Calculated?
Net earnings refer to the earnings of a company relevant to its stock price. Net earnings consist of the amount of income earned after mandatory deductions and withholding like federal income tax and money withheld from employees through the Federal Insurance Contributions Act (FICA).
Net earnings equal the sales or revenue of the company minus the cost of sales, expenses, deductions and taxes and get computed over a specific period of time, such as a quarter or year.
An example: Consider a company with gross sales of $1,000,000 over a 1-year period. Subtract from that number the cost of goods sold: $600,000, the company’s operating expenses: $160,000, and its tax payments: $40,000 — a total of $800,000 for that same period.
This leaves the company with a net income, profit or earnings amount of $200,000 for the year.
Earnings reflect the overall financial performance of the company and factor into computing the key earnings per share (EPS) metric that provides an indicator of a company’s profitability. Earnings per share means the company’s profit/loss attributes to each shareholder of the company.
- General accepted account principles (GAAP) EPS: Calculated by dividing the net income by the number of shares outstanding.
- Adjusted EPS: Calculated by excluding nonrecurring items from net income and dividing by the number of shares outstanding.
Two other types of earnings that are generally reported on a company’s financial statement:
- Accumulated earnings: Net profits made by a corporation not disbursed to shareholders as dividends but retained and reinvested in the company instead.
- Retained earnings: Listed as ownership or equity in the company. Retained earnings consist of the total net income of the company over the company’s life that has not been distributed to shareholders. Shareholders can get these funds via a dividend.
Why Are Earnings Important?
Earnings are one of the most important metrics for the valuation of a company’s stock. They can strongly impact a publicly traded company’s stock price because investors base their investment decisions on the company’s recent earnings and their expectations for its future earnings.
Earnings are often a key factor in investment decisions like whether to hold, buy or sell shares in the company. They also help investors estimate the short and long term performance of the company and identify whether a company is suitable for the portfolio based on investment objectives.
New companies and those that report negative earnings may appear at first glance to be high-risk investments. Keep in mind, however, that some highly successful companies like Amazon.com (NASDAQ: AMZN) started out with years of negative earnings before turning profitable.
Companies that have recently gone public (and have a new and engaging product or service) also typically go through a period of negative earnings before they become profitable. Insightful investors often buy up these promising stocks despite the fact that the associated companies show negative earnings. If a company eventually begins to make money, the associated rise in share price will generally justify their initial investment with increased capital gains on their stock.
Other important metrics:
- Earnings per share (EPS): A metric that provides a key indicator of a company’s profitability. Earnings per share means the company’s profit/loss attributable to each shareholder of the company.
- Total revenue: Total revenue reveals the amount of money the company takes in from its sales of either goods or services. Depending on the company’s expenses and other outlays, a rise in total revenue can lead to increased earnings.
- EBIT: Earnings before interest and taxes (EBIT) is one of the most important metrics stock analysts consider because it takes into account the company’s net income before deducted interest and taxes. Many analysts consider the EBIT growth as more important than total revenue growth since it provides a broader picture of the company’s profitability.
- Price-to-earnings ratio (P/E ratio or PER): This important metric gives you an idea of whether a stock is overvalued or undervalued in relation to its earnings. A high P/E ratio could mean that a company’s stock is currently overvalued or that expectations of higher earnings are already included in the stock’s current price. A low PER could indicate either that the stock is undervalued or that the company’s business model cannot sustain higher earnings, so its share price has fallen although earnings have not been affected yet.
Depending on the type of stock, the PER could be extremely high but is considered justified by the market due to the company’s future prospects and/or high rate of growth. For example, tech and biotech stocks typically carry a high PER due to investor expectations of substantial future profitability.
Is it Better to Buy Stocks Before or After Earnings?
Deciding whether to buy stock before or after an earnings release depends on your investment objectives. For example, if you are a short term trader and want to make a quick profit, then you might buy before the earnings release to speculate on significant stock movement occurring on earnings day.
On the other hand, if you are a long-term investor, then you might wait for the earnings to include the latest earnings into your investment model so that you can better estimate the company’s long-term performance.
Many stocks go through a period of low activity ahead of announcing earnings. This makes sense since institutional investors typically prefer to wait for a positive earnings release before committing more capital.
As a rule of thumb, many investors avoid buying shares ahead of an earnings release because of the uncertainty and extra risk involved. An exception could involve using an option strategy to establish a limited risk position in a stock that could also benefit from increased market volatility.
Companies generally release earnings before or after the market closes. If released before the opening, the earnings result typically increases the volatility of the stock during the day of its release. If earnings are released after the market closes, the stock price may show increased volatility in the after market, but this usually normalizes by the time the market opens the next day.
When a Company Beats Expected Earnings
According to general market theory, a favorable earnings release that beats the analyst consensus should have a positive impact on the company’s stock price, while an unfavorable release should have a negative impact.
For example, if a company announces better quarterly earnings than the analyst consensus expected, then the company’s stock price generally increases. Conversely, if the company announces earnings that fall short of analyst expectations, then the company’s stock comes under selling pressure.
While this makes perfect sense to most people, this generality does not always occur for a number of reasons. Sometimes the price can go down even though a company beats the expected earnings.
- For example, Apple Inc. (NASDAQ: AAPL) might beat analysts’ EPS estimation but miss their number of iPhone sales estimation. In another instance, Netflix Inc. (NASDAQ: NFLX) might beat the market’s consensus EPS estimation but miss its subscriber growth expectation. In both cases, the stock price might decline despite an unexpected rise in earnings.
- Another reason for a diverging stock price from a positive or negative earnings release are the rumors spread among savvy market participants ahead of the release. Such rumors can prompt traders and investors to take positions in advance of the official earnings announcement.
- For example, a company’s stock might rally significantly before a better than expected earnings release but subsequently sells off after the release. You can attribute this to the market having responded to the favorable news spread as a rumor by already discounting it by the time the earnings actually become known to the general public. This is the reasoning behind the old Wall Street adage of “buy the rumor, sell the fact.”
Furthermore, the hype generated by public expectations leading up to the day of the better than expected earnings release can also spark technical buying in the stock ahead of the release. Once the earnings have been made public, shareholders take profits by selling the stock they had previously purchased ahead of the earnings release date, thereby causing the stock price to perhaps surprisingly decline on the good news.
This common scenario can also arise when a company releases lower than expected earnings. In the case of a lower-than-expected earnings call, the stock can subsequently rally as short sellers take profits and investors interpret the negative news as a buying opportunity.
How to Make Money Trading the Earnings Calendar
The earnings calendar shows when each company is due to release their quarterly earnings press releases. The stock price ideally goes up when a company beats earnings estimates and goes down when it misses estimates, although exceptions do exist.
- As the earnings date approaches, traders and investors can focus on how closely the analyst consensus for the reported earnings matches the actual number by looking at the earnings beat or miss on the earnings day.
- Many stock operators also examine a company’s history of earnings releases. If the company has consistently beaten analyst estimates over several quarters and the stock has rallied on each of the earnings releases and a positive release is expected, then the trader or investor can feel confident in a decision to buy the stock before the earnings release.
- Other ways to profit from an earnings release with limited risk is to purchase options. A straddle or strangle involving the purchase of both a put and a call could be profitable if the volatility increases as the earnings date approaches.
The upside of this type of bidirectional option strategy is that the buyer of the straddle stands to make money regardless of the direction the stock may take after the earnings are released, as long as the move is significant and implied volatility does not collapse before they can trade out of the position.
When is Earnings Season?
Earnings season means the time when many large publicly traded companies report their financial results. Federal securities laws require companies to disclose information and file financial statements within 45 days of the end of a financial quarter or year.
The time period that corresponds to earnings season therefore comes around every quarter. It typically begins 1 or 2 weeks after the end of the last month of each quarter in March, June, September and December.