Earnings Season: How to Play It Like The Gurus

Apr 9, 2014   //   by Profitly   //   Profitly  //  Comments Off on Earnings Season: How to Play It Like The Gurus

Even though many of the Profitly gurus go by technical analysis rather than fundamental analysis, they love playing earnings. Why? Because stocks can become very volatile during earnings season! That means they will have bigger movements and there’s huge potential for profit. The stocks are also likely to move past technical levels like support and resistance, so trading on technicals comes in to play.

So what exactly do earnings represent and why can they cause such volatility? Below is a primer on earnings that comes from several websites including Investopedia and The Street.

First things first: earnings are essentially the company’s profits in a given quarter, so it comes four times a year. Think of it as their report card. Take their revenue from selling something, subtract all the costs to produce that product, and you have earnings. This gets more complicated once you dive deeper into it, but we’re going to keep it simple for this post. Earnings=how much money they make. The confusion often comes from terms that get thrown around like bottom line, net income, and profit. These are all synonyms of earnings, according to Investopedia.

So let’s talk about another earnings measure: earnings per share. EPS is a common ratio used by analysts when comparing companies. In order to get EPS, you take the earnings left over for shareholders and divide by the number of shares outstanding. Since every company has a different number of shares, comparing only companies’ earnings figures does not indicate how much money each company made for each of its shares.

Example:

ABC and XYZ each have earnings of $2 million. ABC has 500,000 shares outstanding while XYZ has 1 million outstanding. ABC has earnings of $4 per share while XYZ has earnings of $2 per share.

Before earnings are reported, analysts have estimates on what they think any given company is going to report. This is then compiled into a “consensus” that many look at as the target for earnings. When a company comes out with a number that is higher than the estimate, it is known as “beating estimates” or an “earnings surprise” and the stock usually moves higher (although guidance is a huge part of the report as well). If a company releases earnings below these estimates it is said to be an “earnings disappointment,” and the price typically moves lower. Earnings season is all about expectations, both for the numbers they report as well as the guidance for the future. One of the biggest mistakes people make is not paying attention to the future, and we’ll dive into that a little later.

When a company has cash from making money, it can do one of two things. It can improve products and/or develop new ones, or it can send that money directly to shareholders in the forms of a dividend or buyback. There are pros and cons to each. If they send the money directly to shareholders, you obviously make money, but it can also signal that the company doesn’t have anything better to do with the money itself (running out of ideas). So, more mature companies typically send out dividends or do buybacks, while younger and growing companies tend to reinvest their profits.

But as you dive into this report, keep in mind that because it is such an important document, and because it is released by the company itself, it is in the company’s best interest to present as rosy a picture as possible without violating any Securities and Exchange Commission (SEC) regulations.

So what are the different sections you’ll find in the report? First, take a look at the press release. Then, here are components of the quarterly 10-Q filing:

Part I: Financial Information

  • Item 1: Condensed Consolidated Financial Information
  • Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations
  • Item 3: Quantitative and Qualitative Disclosures About Market Risk
  • Item 4: Controls and Procedures

Part II: Other Information

  • Item 1: Legal Proceedings
  • Item 1A: Risk Factors
  • Item 2: Unregistered Sales of Equity Securities and Use of Proceeds
  • Item 3: Defaults Upon Senior Securities
  • Item 4: (Removed and Reserved)
  • Item 5: Other Information
  • Item 6: Exhibits

There are several ways to go about looking at this report. Some skip the financial data to read about management’s take on the market and the risks facing the company while others jump right into the numbers.

When looking at the financial information, keep the following questions in mind:

  • How did the company perform over the last quarter?
  • How did the performance compare to the previous quarter, or to the same quarter in previous years?
  • Have revenues improved or taken a hit?
  • Is the cost of sales increasing, meaning that it is more expensive to bring in revenue?

You’ll also need to get a feel for risks the company may face in the future. Check out things like legal proceedings. Outstanding lawsuits have to be reported along with a brief description of what the lawsuits are about. Also review Item 1A (Risk Factors). Information here will be detailed and straight to the point, primarily because this is a document filed with the SEC and companies have to be honest and forthcoming.