Earnings Are Stupid (for the most part)
Why does the share price drop after a good earnings?
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Happy Friday!
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My main point in this article:
Newer investors focus WAY TOO MUCH on the share price movement after the earnings report comes out and I will explain in depth where and why they go wrong. This is definitely a newsletter you want to read till the end.
First, for the newer investors reading this, let’s brush up on what earnings are.
What are Earnings?
Every quarter public companies have an earnings report in which the company’s financial documents are on full display. In simple words, the company announces to the public how it performed as a business the prior quarter. These filing statements truly give the bottom line “meat and potatoes” of how a company is performing, growing, or declining. Every quarter (3 months) a company will announce an update in these statements to the public.
Many months ago I did an entire article on earnings named “What are Earning Reports?” which would be a quick read to get caught up more in-depth. In that article, I cover the two big metrics that everyone pays attention to - Revenue and EPS.
EPS (Earnings per share) and Revenue
Earnings per share, or commonly referred to simply as EPS, is the company's net profit (subtract dividends) divided by the # of common shares it has overall. Generally speaking, the higher the EPS the more the company is considered to be profitable. However, a high EPS isn’t the full story on why you should or shouldn’t invest in a company. The EPS is used in the P.E. (Price to earnings) ratio. A common metric to determine whether a company is overvalued or undervalued. P.E. ratio is the price of a share of the stock divided by the EPS.
Revenue (sales) is simply the companies total income from all operations, product sales, goods it provides, etc. Like EPS, revenue doesn’t tell the whole picture of a companies growth or decline. It does not show expenses that can easily offset most of the revenue generated.
What goes into Earnings?
There are countless factors that go into an earnings report that can alter what happens to the share price directly after.
Let me just list a few:
Estimates - Financial reporting institutions such as Zach’s Investment Research and Refinitiv before earnings come out with their estimated earnings numbers for revenue and EPS. If a company doesn’t meet or exceed these expectations there is a good chance the stock might fall after.
Sectors - The sector that the stock is in is extremely important - For example: If you are an investor in a social media company like Snapchat ($SNAP) one of the most important metrics to pay attention to is DAUs or MAUs (Daily Active Users / Monthly Active Users) which is a metric to show how many individuals who have the app are actually using it on a daily or monthly basis. This number has nothing to do with revenue, EPS, P/E Ratios, or any actual cash flow but can be a very important indicator of where the company is going. Furthermore, a behemoth company like Walmart is not going to post double-digit revenue growth in a quarter but up-and-coming high-flying tech stock might be expected to.
Day Trading / Options pricing / Short interest - Depending on the earnings date, large amounts of options activity (exercising of shares, buying, and selling, etc.) can affect the share price of a company before and after earnings. Along with this, a large amount of short interest (amount of people shorting the stock) can have a big influence on the volatility of the stock post-earnings especially if the company has a big earnings beat and a short squeeze occurs. Day traders love earnings love to trade around earnings because volatility and volume are piping hot.
Future guidance - A very important part of earnings that a lot of beginners overlook is future guidance. The future guidance is usually announced by the CEO during the earnings call. A company can have an amazing quarter but the CEO could say on the earnings call that he/she expects the next quarter to have a downturn and institutions are rushing to sell. I can’t express how many times I have seen this happen.
The Perfect Earnings
By now, you probably have realized that the title of this article is an exaggeration. Earnings aren’t stupid, but many times the way the people react to them is.
Let me explain: There are so many factors and moving parts that go into earnings that there is absolutely no possible way to 100% attribute the share price movement post-earnings to one singular metric. Often times we see financial media outlets say things like this post-earnings: “$SNAP missed on its EPS and that’s why the share price is down this morning” and then next quarter it’s “$SNAP missed on its DAUs and that’s why the share price is down this morning” and then the quarter after it’s “$SNAP missed on revenue and EPS, but it’s up because DAUs are up”. Do you see the trend?
Let me fill in the blanks: Financial media outlets are playing a constant game of trying to find meaning where no meaning is meant to be attributed (or a way of controlling the narrative to be even harsher). If the share price is down post earnings all they have to do is find one metric that isn’t good (which is always possible to find) and then attribute the share price drop to that metric. On the flip side when the share price goes up after earnings they just have to find one good metric and Voila! we know now the reason why a company is going up or down! (sarcasm)
Noise
A data scientists’ worst nightmare and the constant never-ending career battle is noise. Noise is meaningless information in a data set that can false sense of accuracy or false conclusions. There is noise in every type of data set and the stock market has TONS of noise. Trust me when I say that there are people out there that think that corn futures are affected by moon phases and thus make bets off such “data”. Totally not noise.
Earnings Reports are like a conglomeration of noise on steroids. I’ve had people say that the share price of a company fell after earnings because “the CEO didn’t sound confident during the earnings call”. Could that be the reason? Sure. Could that just be a complete assumption and the attempt of assigning meaningless information to an outcome? Absolutely.
I may sound jaded - and it’s because I am. I have seen companies report incredible earnings and the share price fall after leaving myself and many others scratching their heads. Unfortunately, when I was a beginning investor this lead me to run to the hills and sell my shares for a loss on countless occasions. A company that is infamous for having a sell-off/share price drop after earnings is Apple!
Share Price Down ≠ Bad Earnings
If you follow me on Twitter you have probably have seen me say “ignore the noise, follow the numbers” a million times. My system goes a lot like this: I don’t care what happens to the share price of stock immediately before or after earnings and I especially don’t care what the talking heads on CNBC have to say about it. I ONLY CARE ABOUT THE NUMBERS. So far this system has worked out for me because if you follow the numbers things tend to also fall in place.
Let me give a basic example (if you read anything it should be this):
You own shares of XYZ company and the market cap of the company is $1 Billion. XYZ Corp. posts earnings of $40 million dollars of revenue for the quarter and since it’s Q4 the total revenue for the year is a clean $120 million. Q1 was $20 M, Q2 was $25 M, Q3 was $35 million in revenue. As you can see, the revenue is growing at a fantastic rate! Q3 to Q4 QoQ revenue growth is 14.2% and the revenue growth for the year from Q1 to Q4 is an incredible 100%. Along with this, the EPS grows at a similar rate.
Earnings reports comes out annnnnnnndddddd share price drops. How?! HOW!!! After you collect yourself you read that Zach’s estimate was 90% revenue growth for the year and people are selling shares of XYZ because a 10% beat “isn’t enough”. I can’t tell you how many times I have seen something like this play out.
Let’s take a step back and think for a second. Maybe..just maybe the estimates were too high because it’s an amazing company and now the only way to please anybody is to post the most outrageous earnings beat every quarter. cough cough Amazon cough Apple…
This is my favorite type of earnings and as some of you know I actually root for this outcome.
Here’s why:
If you are long a stock and believe in the company’s 5-10 year outlook you want to accumulate as many shares as possible. This isn’t a stock that you heard on the subway, we are talking about a stock that you have done legitimate research and have spent many hours reading about, listening to earnings calls, etc. When numbers are up but the share price slumps you are essentially getting what’s called “discount earnings” and as a long-term investor you should be ecstatic.
In the example above about XYZ Corp. I said the market cap of the company is $1 Billion before earnings. Remember the market cap of a company is the share price multiplied by the number of outstanding shares. If the share price falls after earnings and the market cap falls 10% to now $900 million the fundamentals of the company just completely changed. Yes, your shares are “worth less” since they dropped in value but the revenue of the company went up along with it the overall valuation, P/E ratio has lowered, etc. as well. So out of this earnings report what you gained was a more favorable valuation, proof that the company is growing at a steady pace, and now an opportunity to add more shares cheaper than you could have yesterday.
Below you will see $AMD over the past year. The “E” represents earnings over the past year and you will see that the share price actually dropped the day after 3 of the 4 earnings displayed.
Number wise every single earnings displayed were good - can you imagine if you sold after the earnings on the far right and missed the move from +45% to +81% because you got spooked after it opened red the next morning?
This is why I emphasize so heavily knowing the numbers because they will tell you everything. If a company continues to post amazing numbers and share price is staying stagnant or even falling after earnings the fundamental valuation of the company only gets better and better.
In conclusion,
The perfect earnings for me are when I believe in the vision of a company 100%, they post amazing numbers, and for whatever reason/noise listed above the share price drops giving me another opportunity to load up the truck before taking off.
Hopefully, this helps, I know nothin’
I know I put this at the bottom of a lot of my emails… but if you just share this with a friend that is curious that would mean the world to me!
BEFORE YOU GO
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