Every publicly-traded company must produce a financial report, and the press release communicating this information to the public is called an earnings report. Earnings season is when publicly traded companies announce their financial results to the world. Earnings season is also the time of year when magazines report which companies fell short of expectations, what factors led to companies beating predicted earnings, and which firms will likely see a change in leadership. But how does company earnings season impact stocks?
The Importance of Earnings
Earnings are the after-tax net income or profits that a company earned in a given timeframe. The term ‘earnings’ is synonymous with net income, profit, and “the bottom line”.
Earnings are essential to understanding a company’s profitability, or lack thereof. Publicly traded companies are legally required to report their earnings on a quarterly and annual basis, depending where they are based. For example, the UK changed its regulations in 2014 to say the reports only had to be released twice a year.
Other companies may release earnings reports because shareholders want them to do so. Furthermore, companies that hide this information are treated with suspicion because people assume that they’re hiding bad news. That will scare investors away from the company’s stock.
The Impact of Earnings Reports on Stocks
Earnings per share are calculated by dividing the company’s earnings by the number of common shares outstanding. The EPS shows how much the company earns per share.
A higher EPS than average indicates that a stock has a higher value compared to others in the same industry. When a company’s earnings go up, so does the EPS as long as the number of shares remains the same. When the EPS goes up, the stock is considered a better deal than stocks with lower EPS.
This means higher earnings and EPS often result in a higher stock price. On the other hand, a stock’s value tends to go down if the stock’s EPS goes down or misses what analysts were forecasting.
How Earnings Are Affected by Earnings Estimates
EPS is generally considered the most important number reported during the earnings season. However, the stock market’s behaviour is driven more by performance relative to predicted earnings.
Stock analysts issue earnings estimates before earnings season and research firms will compile the forecasts by various analysts into what is called a consensus earnings estimate. When a company’s earnings exceed the estimate, it is called an earnings surprise. This generally results in higher stock prices. If the company’s earnings are below the estimate, the stock prices will often fall. It is the stock’s performance relative to the expectations that leads to the stock price going up or down.
Earnings estimates can affect stock price, too. If the estimates predict strong earnings, the price may rise as people invest in it. On the other hand, the rising stock price is no guarantee the stock will be profitable. Yet the system is self-correcting since a stock with a high valuation but no earnings will eventually fall in value.
Furthermore, companies are legally required to report anything that might significantly impact their share price. Good share trading platforms will allow you to quickly buy or sell stocks as soon as the information comes out. In the meantime, analysts will quickly adjust their estimates for the stock’s next earnings report.
Earnings and earnings per share are the most important indicators of a company’s financial health. However, they aren’t the only factor used by investors to determine a stock’s price, so make sure that you only use them as a complementary tool to make decisions.