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Company earnings releases are major events for stock traders and investors, telling them in words and figures how the company has performed recently and often providing guidance on how the following months will go. They often cause a lot of volatility in the reporting stock’s price, and so it’s important to understand why that volatility happens and to have appropriate risk management in place.
If you are taking a position in a stock, you need to be aware of the position’s total notional exposure and make sure you have guaranteed stop losses in case the market moves swiftly against you.
What are earnings?
Simply put, they are a company’s profit and loss account and its balance sheet. Publicly traded companies in most jurisdictions are legally required to report their financial results at least twice a year and up to four times a year on a quarterly basis. They may also be required to put out trading statements between earnings reports, which don’t have as much detail and may not contain full profit and loss accounts.
Key figures include revenue, net income and earnings per share (EPS), which is net income divided by the number of shares outstanding. However, some companies also put out other figures, which are normally the reported figures adjusted to discount certain items. They do this because they think it better represents their actual business performance and makes annual changes more comparable. The markets may pay closest attention to these figures.
Here are some of the key parts of an earnings statement to watch:
Adjusted earnings per share: This is different to the accounting EPS (reported under GAAP or IFRS rules, for example), which reports all earnings and expenses in a year even if they may be due to non-recurring factors. Adjusted EPS allows the company to report earnings in a like-for-like comparison format by discounting one-off expenses or income gains.
Revenue is the ‘gross income’ that a company actually receives during a specific period. For some stocks, revenue can be a big driver in the initial stock reaction. This is particularly true for growth stocks, which may be investing more money than they are earning as they expand. Investors can be comfortable with such a scenario, so long as revenue keeps growing at a strong pace to warrant the heavy investment in scaling up the business.
Guidance can be one of the biggest drivers of the stock price in the wake of an earnings announcement. Stocks are priced according to expected future returns, and so dramatic changes up or down in earnings guidance unsurprisingly can have a major influence for a stock.
How to trade the result
You may have seen this scenario: a company puts out earnings, including a 25% rise in revenue and a 20% rise in its key profit measure, and yet the share price drops 5%. On the face of it, the figures appear to be strong, so surely investors should reward the company by buying shares?
There can be several reasons for the share price reaction, including weak guidance for coming months or a strong run in the share price in the lead up to the results. However, one of the most common reasons for a share price reaction that appears to go against the result is that markets are comparing the figures against expectations, not just the prior year’s results. Revenue may have risen 25% and the key profit measure by 20%, but if the market was expecting a 35% and 25% rise, respectively, then the growth missed expectations.
Major market data providers such as Bloomberg, Thomson Reuters and FactSet poll the major analysts covering the stock ahead of an earnings release to generate consensus earnings numbers. Investors need to be aware of these consensus figures ahead of the results announcement.
It is also worth having a look at how the stock has traded after previous earnings releases. A stock that has a reliable history of beating estimates and rallying on the release is probably a reasonable one to go long on. A stock that consistently misses earnings estimates and sells off sharply is probably one to short. Of course, history does not predict future performance and a solid analysis of a firm’s past earnings reports, and an analysis of how the stock has been performing in a technical sense will help guide any short-term investment decisions as well.
Trading a CFD (contract for difference) is a good way to maximise a big gain in the stock by adding leverage to your position, but should only be attempted with a firm guaranteed stop loss ahead of time. IG sometimes offers binary options on major stocks, which makes it even simpler to speculate on the outcome of an earnings result.