In this article, we provide the outline of a strategy for trading a stock during some of the most exciting times in its financial year: when earnings reports are released. In particular, we’ll look at the four most important metrics you need to know about any company you invest in.
Because the earnings report gives a known trigger at a specific moment for a stock price to rise or fall, earnings season is a great time to be a day trader. However, trading equities during this time is a high-risk, high-reward endeavour because the reports may lead to big price swings – good or bad.
What’s this all about? A publicly traded company is required by law to provide periodic earnings reports, which provide information about its performance during the preceding accounting period. Financial performance is made public every three months in the United States, or quarterly. In Europe, businesses typically report earnings every six months. These reports are typically issued by the businesses either after the market closes or before the opening bell, outside of normal trading hours.
Why do investors monitor earnings so closely?
If the figures in a recently released report are good, the stock usually rises as soon as the market opens. Conversely, if the numbers tell a sad story, the stock typically declines, sometimes dramatically. Investors will compare accounting metrics, including the four headline numbers listed below, to what experts predicted.
Analysts not associated with the company do their own financial analyses to produce forecasts in the run-up to each earnings report, taking into account the company’s own projections for the upcoming quarter. The direction of a stock is usually determined largely by whether the actual results exceed or fall short of expectations (which will have been priced into the market price.
Let’s therefore look at the main numbers analysts and investors gravitate to:
The four horsemen of earnings reports
- Revenue
The worth of all of the company’s income-generating transactions is described as revenue. This figure takes only the incoming cash (and comparable assets) into account and does not include the outgoing expenses, such as wages for employees and supplier payments. It goes without saying that, in order to succeed, a company must generate revenue and make sales. Revenue is therefore arguably the most important number in any earnings report.
Tesla’s revenue, for instance, would be $75,000 if it sold a single Model S car for $75,000 in the past three months. That would undoubtedly be a terrible quarter for Tesla! Let’s examine Tesla’s actual sales statistics for the second quarter of 2020 instead. Tesla’s revenue was estimated to be $4.67 billion; however, the company really recorded $6.04 billion, a 29% increase over expectations.
FAQ: Where can I get the anticipated and real numbers? The aforementioned image comes from Earningswhispers.com, one of several websites, also including MarketWatch and Yahoo Finance, that provide a wealth of information relating to earnings reports.
- EPS (Earnings Per Share)
The profits a business generates are called its earnings, which are calculated (in a nutshell) by deducting expenses from income. The cost of producing the Model S could be $20,000, while the selling price might be $50,000, resulting in a $30,000 profit per unit. After multiplying this by however many cars they sold, we also need to deduct expenses like facility rent, depreciation, wages, and taxes. Finally, we take it a step further by analysing the profit per share.
Assume, for the sake of example, that Tesla has no preferred shareholders, who are first in line for dividend payments. The EPS would then be the company’s net income divided by the number of shares, or how much someone holding 1 share would pocket if all earnings were distributed. Returning to Tesla’s actual earnings for the quarter in question, we can see that the business posted an EPS of $2.14, while predictions were for a loss of $0.71.
- Product sales / Increase in users
Like many accounting concepts, EPS is simple in principle but gets a little messy in practice. An increase in a platform’s user base is comparatively straightforward.
Although many firms concentrate on selling physical products, such as Tesla with its vehicles and Apple with its iPhone, a company like Facebook’s main focus is probably on the number of new users it attracts to its service. Because these services (and sometimes goods) are at the heart of the business’s revenue model, they provide investors with a solid picture of where the company’s fortunes may be headed.
Tesla shipped 90,650 automobiles in the second quarter of 2020, or around 2,250 more units than in the first quarter. This, however, is a drop when looked at in year-to-year terms: worldwide, there were 95,200 units delivered during the second quarter of 2019. A shrinking customer base or declining popularity is generally bad news for a “lifestyle” brand.
- Earnings Guidance
The majority of firms will tell investors what they anticipate happening in the next quarter. Investors who purchase the stock in hopes of growth will be pleased if a company predicts rising sales and earnings per share in the new quarter, but they will be let down if expectations are lower than before. A stock often falls even after a solid earnings announcement that beat predictions for EPS, sales, and user base, only because the firm has forecast that the next earnings report will not be as good.
Tesla often provides advice on anticipated future car sales. Due to the ambiguity surrounding the COVID-19 outbreak, the firm did not alter its 2020 forecast of 500,000 vehicles in Q2.
How to purchase shares following earnings reports
When earnings are published, there are three things you should do as an inexperienced trader:
1. Ensure that all four indicators exceed expectations.
2. Watch the market: did the price increase after trading hours?
3. If a jump in price occurred, seize the momentum.
First, by checking that all the main indicators exceeded consensus predictions, we confirm that the report was “good”.
The second point takes into account that prices are manipulated by market makers and computer algorithms, even outside of regular trading hours. You know the company’s financial outcomes were well-received if these experts favour the stock.
(Source: WarriorTrading.com)
Prices will often “gap” up after a positive earnings report, with prices rising during after-hours trading. This implies that trading at yesterday’s closing price is no longer an option. You have to wait for the next available market price, which is now higher by the gap amount. In the wake of the gap, high-frequency traders may then drive the price up even more before you, as a retail investor, have a chance to place a trade. Even so, missing the first move doesn’t mean you’ve lost your chance. Let’s not overlook the earnings report’s fundamental message: the company is performing better than expected, and until new data suggests otherwise, the stock price should continue to perform well.
Thirdly, the confirmation of good business performance provided by an earnings release that’s better than anticipated is a key support for the stock price. It’s likely that its short-term momentum will persist. The stock may still be purchased through a variety of order types, including call options. In any case, the goal is to buy as soon as possible after the market opens. One strategy, for instance, is to buy on the open of the 2nd 1-minute candlestick.
Another choice you’ll have to make is when to take profits. Exiting any given trade is a personal preference. Typically, day traders will use different timeframes as guidelines, perhaps selling the stock at the end of the day or two weeks later, either for a profit or cutting losses if the price falls back below the initial entry point.
Whatever specific tactics you employ, a word of caution is in order. Earnings season typically sees both high trading volumes and significant price swings for the stock in question. Whether you’re an old hand or still learning the ropes of day trading, you’ll be competing against a lot of “smart money” – don’t let yourself be carried away by the excitement of what appears to be a sure thing.
