Interpreting Earnings Results: A Guide for Investors
When a company reports its earnings, the immediate reaction in the stock market is often confusing. Why do stocks drop on good earnings, or rise on bad ones? These fluctuations can be perplexing until you understand the underlying factors and how the market sets its expectations. In this article, we delve into the nuances of earnings analysis, guidance, and how to gauge whether earnings results are truly shaping up to be good.
Understanding Market Expectations
Earnings are considered 'good' or 'bad' in comparison to what the market expects. This means that if a company exceeds the consensus forecast set by analysts, the earnings are deemed good. It's important to exclude one-time gains or losses when measuring a company’s performance, as these can skew the results.
Key Drivers: Earnings vs Guidence
The primary drivers of stock price movement after an earnings report are earnings and guidance. Earnings reflect the company's performance over the last quarter, while guidance projection looks ahead and can carry significant weight if the market believes it. A positive earnings report combined with lowered guidance, for instance, might indicate potential future challenges, leading to a drop in the stock price.
Decoding Earnings Reports
Understanding whether earnings are truly 'good' requires a comprehensive analysis. Here are some steps to help you evaluate earnings:
Graphing Earnings Over Time
Start by plotting earnings over the past few years. Analyzing the patterns helps determine if the company’s earnings are growing each year. Consider analyzing the growth rate and identifying the best quarter (often the 4th quarter for many companies).
Revenue and Cost Analysis
Earnings are the bottom line, calculated as revenue minus costs. But to understand the significance of the earnings number, you need to dissect what went into it. Include revenue and cost data in your graphs to get a clearer picture.
Market Segmentation
Many companies operate in multiple end markets. For example, a company might provide revenue numbers for four different segments. Analysts closely scrutinize these segments. If one segment is growing tremendously, such as Venmo for PayPal or Data Center sales for Nvidia, the stock might be valued much higher than just looking at overall revenues.
Listening to Market Sentiment
Stay informed about the company's earnings conference calls and read articles around the time of each earnings report. Understand what the market cares about most, as this can give you insights into potential stock movements.
Setting Projections
Create your own projections based on past earnings, guidance, and market expectations. Calculate a target stock price based on these projections, giving different pricing assumptions to different business segments. Compare the earnings report to both analyst projections and yours to determine if the company has exceeded or failed to meet expectations.
The Conference Call Aspect
Even after a positive earnings report, the conference call can turn the stock price in an unexpected direction. If the management presents overly optimistic guidance, the stock might rise initially but plummet after the call if it doesn't meet the expectations.
Long-Term Considerations
While quarterly earnings can provide valuable insights, the long-term success of a company is not dictated by short-term stock price movements. For a deeper understanding, read 'The Intelligent Investor' by Benjamin Graham, a seminal work recommended by Warren Buffett.
In conclusion, evaluating earnings results involves a thorough analysis of both current and future performance indicators. By understanding market expectations, interpreting earnings, and setting appropriate projections, you can make more informed investment decisions.