Earnings season comes to the stock market four times a year. Everything you wanted to know about earnings season but were afraid to ask.
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Stocks are businesses. Good stocks are good businesses. The only way to evaluate a business is to look at its financial numbers. Is it making money? Is it investing in growth? What's going on inside?
In exchange for the legal and financial benefits of incorporating as a public company, corporations must follow specific regulations to publish their financial information. The Securities and Exchanges Commission governs this in the US. Several of these regulations require specific reports from public companies—and many of these are of great interest to investors. In particular, the quarterly and annual 10-Q and 10-K filings have great information for value investors.
Under penalty of law, corporations have to provide accurate financial information in these filings. This is good news for investors!
What is a 10-Q Filing? What is a 10-K Filing?
By law, publicly held US corporations must file SEC form 10-Q (PDF link) or SEC form 10-K (PDF link) every quarter. These forms provide important information about the business's financial performance for investors, likely investors, regulators, and anyone else with a stake in the company.
In a given year, a business will file three 10-Q (quarterly) forms and one 10-K (annual) form. Because most public businesses follow a consistent fiscal year which matches a calendar year, there's often a glut of these published around the same time every year. (Per SEC regulations, these forms are due 35 days after the close of each respective fiscal quarter.)
What is Earnings Season?
Generally these 10-Q and 10-K reports get filed in January, April, July, and October. The term earnings season refers to these rough month periods where most stocks report their quarterly (and annual) progress. As the money each company earns is ultimately its most important financial metric, interested parties review these filings closely to measure the performance of the businesses.
No business runs itself in the absence of the market as a whole; greater macroeconomic trends affect supply prices, customer demand, and even the availability of financing. Yet each business is its own business in its own way, where it may have a strong or weak quarter despite the performance of the rest of the market. Yet the term "earnings season" is often used as financial media commentary on the economic performance of the US as a whole.
Why Does Earnings Season Matter?
In general, it's better for a stock price if the reported earnings meet or exceed expectations and worse for the price if the reported earnings fall below expectations. Some investors watch for these numbers as a sign to buy or sell, and prices move accordingly.
What are expectations? Great question!
When companies release their earnings information, they often include an earnings estimate for the next quarter and the year as a whole. These are estimates—the numbers aren't official until the quarter is over and done and the accounting is finished—but they represent the business's idea of what it's going to do and how well it's going to do it.
For example, if Hot Topic releases guidance of earnings of $0.29 to $0.33 per share, it's because the management believes the business can really generate that amount.
If in the next quarter HOTT makes those numbers, investors will be happy. If HOTT exceeds those numbers, the stock is likely to go up (depending on guidance for the next quarter). If HOTT misses those numbers, the stock will likely go down.
Other entities will predict earnings too. For stocks that are large enough to have analysts cover them, those analysts will also be looking for specific targets when it comes time to release earnings. Again, any gap between expectations and reality is likely to move the stock price in the short term.
If you pay very close attention, you can see that earnings reported by a single company in the Dow Jones Industrial Average will move the entire average up or down by several points. As that number is often used as a simplified measurement of stock performance as a whole, a weak earnings report from Apple or IBM may cause nervous investors to sell stocks in completely unrelated sectors and industries and businesses.
This behavior—both of stock prices on quarterly earnings numbers and of investors on reacting to daily fluctuations is predictable but not always sensible.
How Should Value Investors Treat Quarterly Earnings?
The SEC demands these quarterly filings for good reasons: to improve business transparency, to increase shareholder understanding of financial statements, and to enforce truthful and auditable financial accounting. Yet not all businesses can be measured on a quarter by quarter basis.
For example, a cyclical business such as a retailer which makes most of its money thanks to Christmas shopping or a technology supply company which makes most of its money in the third quarter selling components to a consumer products company which sells most of its products in the fourth quarter may have three dismal quarters a year because it spends its money preparing for that one amazing quarter. Alternately, a company which invests one year out of every three or four in building a nice new factory to accelerate its business may report one mediocre year, one decent year, and two amazing years all in that same cycle.
Furthermore, the notion of setting earnings expectations on a quarterly cycle and rewarding or punishing the price of a stock based on that predictability is easy for corporate officers to exploit, especially as they're often highly compensated in stock (so of course they want the price to fluctuate in predictable ways).
It's tempting for a company to underplay expectations a little bit, in the hopes that exceeding estimates reliably will cause a continual rise in share prices.
For many years, Google failed to provide quarterly guidance and future earnings estimates. That never stopped analysts from covering the company and making their own predictions, but the stated reason for avoiding this was always to get out of short-term thinking and let the business's performance speak for itself.
Even so, these 10-Q and especially 10-K statements provide great information for value investors. It's impossible to calculate free cash flow and owner earnings without the information in them, for example.
Ultimately the successful value investor strategy is the same as it always is:
- Gather good information where you can, especially from SEC filings.
- Understand the nature of the business and why the numbers are what they are.
- Let other people make their own decisions, and be prepared to take advantage of good opportunities to own great businesses.
Earnings season offers an opportunity for you to learn more about the businesses you own and may want to own. It also offers opportunities for you to pick up great businesses at good bargains just because the daily, weekly, and quarterly fluctuations of investor sentiment don't always reflect the patient understanding that rewards value investors over the long term.
When companies release their numbers, pay attention—but put them in their proper context. A company that grows reliably year over year is better than a company that sometimes beats estimates but doesn't have the proper fundamentals.