Investing

Earnings season can help you succeed as an investor: It's 'the clearest way to check in on a company'

Earnings season can help you better understand the stock market and your investments.

Twenty/20

Now that it's mid-October, you may be deep into spooky season. For market-watchers, another (admittedly not as fun, but still potentially scary) seasonal tradition is underway: earnings season. That's when publicly traded companies issue reports detailing their financial results from the previous quarter — in this case, the one that ended on September 30 — and forecast operations for the next quarter, for the current year, and for the upcoming year.

For investing professionals, analyzing earnings season is a practice in looking forward and looking back, as they assess not only how companies have performed but also how they performed compared with those firms' previous prognostications about their future profitability. That performance then factors into the the analysis of the companies' prospects going forward.

As markets and the index funds that track them can move based on earnings news, this stuff can have an effect on your portfolio.

If that all sounds rather complicated and you'd rather let your investments ride this month while you curl up and watch "Hocus Pocus" no one would blame you. But taking some time to understand the basics of earnings season means you could get valuable insight on the direction of the overall market as well as individual stocks in your portfolio and on your watch lists.

Why you should care about earnings season

Earnings are important to investors because they are one of the fundamental building blocks driving stock market returns.

When you buy shares of a publicly traded firm, you're buying into a piece of that company's earnings. Theoretically, a firm's earnings directly drive the stock price.

Consider the following calculation from Calamos Wealth Management. Say you owned a stock that costs $100 per share and that reports earnings of $10 per share. If earnings increased by 5%, to $10.50 per share, then the stock price would grow by 5% too, to $10.50.

So at the very most basic level, the projected growth in corporate earnings can tell investors how stock prices are likely to behave in the short-to-medium term.

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Among the major factors complicating this math behind earnings and share prices: Investors are forward-looking and are therefore willing to bid up the price of a stock in anticipation of future earnings growth.

"In the stock market, just like in anything else, you can overpay," says Sam Stovall, managing director of U.S. equity strategy at investment research firm CFRA. "That's why investors look to the price-to-earnings ratio. Like real estate buyers look at price per square foot, investors look at a stock's price per share of earnings."

Assessing the price that investors pay for stocks based on their current or future earnings, then, can tell investors whether the stock market looks overvalued or undervalued relative to its history.

What the current earnings picture means for the stock market

How the earnings picture for the overall market is currently shaping up depends on how you look at things. Companies regularly publish earnings "guidance" — a range in which executives expect earnings to fall in a particular quarter or year. Investors often sell stock in companies that fail to meet these projections and reward companies that consistently beat them.

So far, of the 49 companies in the S&P 500 that have reported third-quarter earnings, about 86% have reported earnings that beat expectations, according to data from Refinitiv. "By the time all the companies report, that number will likely settle somewhere in the 70s," says Jeff Buchbinder, a market strategist at LPL Financial.

That would still make for an above-average quarter. Since Refinitiv began tracking the data in 1994, 65% of companies beat expectations in a typical quarter.

Companies are beating their targets by big margins, too. On aggregate, companies are reporting earnings 23% above expectations, compared to a historical average of 3.5%.

Markets have responded to this impressive performance with a yawn, though, so far: Stocks receded slightly this week despite positive early earnings results.

Why the ho-hum reaction from investors? For one thing, because missing quarterly guidance can ding stock prices, executives typically err on the side of conservative guidance, says Buchbinder. What's more, even though companies are exceeding expectations, the Covid-19-related economic shutdowns have kept those expectations low. All in all, Wall Street analysts expect earnings to have declined by nearly 19% in the third quarter.

"Far more important than the results themselves will be guidance on the future path of earnings," Credit Suisse analyst Jonathan Golub wrote in a recent note. Following a projected 19% dip in 2020, analysts expect stocks in the S&P 500 to boost earnings by 27% in 2021. Much of that growth expectation is already baked into stock prices. The S&P 500 currently trades at 22 times the expected earnings for the next four quarters, well above its historical average P/E ratio of 15.

And a rosier earnings picture alone isn't likely to boost stock prices anytime soon, Steve Boyd, senior vice president at First Financial Equity, told CNBC. "My biggest concern is getting that additional stimulus out there. The market is counting on additional stimulus as a bridge to the vaccine."

Use earnings reports to assess an individual stock

If you own individual stocks in your portfolio or are considering adding a few, use earnings season to assess those names. "At a very high level, it's the clearest way to check in on a company," says Bill McMahon, chief investment officer of active strategies at Charles Schwab Investment Management.

Dig into a company's reported financials with an eye toward how the pandemic may have affected its business: "The picture at a work-from-home tech company is going to be very different than one for travel and entertainment companies," he says.

Favoring companies with growing earnings is a good start, but investors should understand that earnings are a "fudge-able" accounting metric, says Stovall. "Cynics call operating earnings 'earnings before bad stuff,'" he says.  

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Try to put earnings numbers into context. Ideally, you'd like to see firms that can turn fast-growing revenues into even faster-growing profits, McMahon says. Look for expanding operating margins and growing free cash flow (cash left over after the company spends to maintain and expand its operations) alongside growing earnings.

And if you're digging deep into a company, listen to the earnings call — a conference call between company management and analysts, investors, and members of the press. (Companies typically release a transcript as well.) The call will usually provide information about changes in the company, such as new products, investments, or shake-ups in management. You may gain insight on executives' assumptions about the growth of the company.

"They may say, 'We expect to grow 10% next year,' but that may be based on an assumption about growth in U.S. GDP. Maybe you think the GDP projection is low or high, and you can adjust your assumptions accordingly," McMahon says.

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