Earnings reports and stock prices: understanding the connection

What are earnings reports? 📊

At their core, earnings reports are quarterly financial statements that publicly traded companies are required to file with the Securities and Exchange Commission (SEC) in the United States. These documents, also known as 10-Q filings (or 10-K for annual reports), serve as a comprehensive snapshot of a company's financial health and operational performance over the past three months. 

The centerpiece of any earnings report is the income statement, which breaks down how much money the company made (revenue) and how much it kept after expenses (net income). But the star of the show is often Earnings Per Share (EPS), a metric that divides net income by the total number of outstanding shares. 

EPS is the yardstick by which a company's profitability is most commonly measured. For instance, when Apple reported an EPS of $1.52 in Q1 2023, beating analyst estimates of $1.43, it signaled to investors that the tech behemoth was more profitable than expected, despite macroeconomic headwinds.

Revenue, often called the "top line," is another critical component. It represents the total amount of money a company brings in from its core business activities before any costs are subtracted. In  📅 Q4 2022, Amazon's revenue hit $149.2 billion, surpassing Wall Street's expectations and suggesting robust consumer spending during the holiday season. 

However, high revenue doesn't always translate to high profits. In the same quarter, despite its revenue beat, Amazon's net income fell short of estimates due to increased operating expenses.

Earnings reports also include the balance sheet and cash flow statement. The balance sheet offers a point-in-time look at a company's assets, liabilities, and shareholder equity, providing insights into its financial structure and liquidity. Tesla's strong cash position of over $22 billion, as reported in Q3 2022, reassured investors about its ability to fund ambitious expansion plans. The cash flow statement, meanwhile, tracks the movement of cash in and out of the business, broken down into operating, investing, and financing activities. High operating cash flow is particularly prized as it indicates a company's core business is generating robust cash, not just accounting profits.

Beyond these standardized components, earnings reports often feature industry-specific metrics that offer deeper insights. For social media companies like Twitter (now X), Daily Active Users (DAUs) and Average Revenue Per User (ARPU) are scrutinized as closely as EPS. In the oil sector, metrics like barrels of oil equivalent (BOE) production and lifting costs are critical. 

Companies issue these reports quarterly, typically 4-6 weeks after the quarter ends, creating the phenomenon known as "earnings season." But the annual report, or 10-K, filed after the fiscal year, carries even more weight. It includes audited financial statements, a more extensive management discussion, and detailed disclosures about risks, legal issues, and corporate governance. When Enron's fraudulent practices were finally exposed in its 2000 annual report, it sent shockwaves through the market, reminding investors of the critical importance of these documents.

Wall Street analysts, armed with financial models and industry expertise, provide estimates for key metrics like EPS and revenue. These forecasts set the bar that companies must clear. When Nvidia smashed expectations in Q1 2024 with an EPS of $1.09 versus the expected $0.92, driven by AI-chip demand, its stock skyrocketed. It's not just the absolute numbers that matter, but how they stack up against the market's collective wisdom.

How Earnings Reports Impact Stock Prices

When a company releases its quarterly figures, the market doesn't simply react to the numbers in isolation; it judges them against a backdrop of pre-existing expectations. Affirm Holdings, a fintech company, saw its stock plunge over 20% in February 2023 after reporting a wider-than-expected loss of $1.75 per share, compared to the anticipated $1.53. The absolute size of the loss, while significant, was less important than the fact that it exceeded analysts' already pessimistic forecasts.

Earnings reports typically trigger immediate price movements in after-hours trading, as institutional investors and algorithms quickly digest the news. When Microsoft beat both EPS and revenue estimates in Q3 2023, its stock jumped 5% within minutes of the report's release. This after-hours surge often sets the tone for the next day's regular session. However, the story doesn't end there. As more market participants analyze the report and listen to the earnings call, sentiment can shift. In Microsoft's case, cautious guidance about cloud growth caused the stock to give up its gains and close lower the next day.

Over the long term, stock prices tend to follow earnings growth trajectories. Amazon's meteoric rise from $10 in 2006 to over 💵 $3,000 in 2021 mirrors its transformation from a modest online bookstore to an e-commerce and cloud computing juggernaut, with earnings growing from pennies per share to tens of dollars. This alignment isn't always perfect — valuation multiples expand and contract based on growth expectations — but sustained earnings growth is the engine that drives long-term stock appreciation.

Earnings surprises 🤑

An earnings surprise occurs when a company's reported figures significantly deviate from Wall Street's consensus estimates. These surprises, whether positive or negative, often catalyze dramatic stock price movements. 

In May 2022, Target's stock experienced its worst day since Black Monday in 1987, plunging 25% after the retailer's EPS of $2.19 vastly undershot the expected $3.07. The surprise wasn't just a numerical miss; it revealed deeper issues like bloated inventories and rising costs that reshaped investor perceptions.

Positive surprises, while less dramatic, can be equally impactful. In August 2022, Walmart's stock surged 5% following an EPS of $1.77 that handily beat the $1.62 estimate. More than the earnings beat, investors were enthused by Walmart's ability to navigate inflation pressures better than peers, boosting confidence in its operational prowess. 

Academic research, such as a seminal paper by Victor Bernard and Jacob Thomas in 1989, has shown that stocks experiencing positive earnings surprises tend to outperform in the months following the announcement, a phenomenon known as post-earnings announcement drift (PEAD).

The magnitude of an earnings surprise matters, but so does its context. When chipmaker Nvidia reported Q1 2024 earnings that exceeded expectations by a staggering 19%, its stock soared 📈24% in a single day. This outsized reaction was due not just to the numerical surprise but to its implications; the beat was driven by surging demand for AI chips, suggesting Nvidia was at the forefront of a transformative technology wave.

Beyond the numbers 💹

While EPS and revenue garner the headlines, savvy traders know that earnings reports contain a wealth of information beyond these headline figures. Forward guidance — a company's projections for future performance — often moves markets more than historical results. In January 2023, 3M's stock dropped 6% despite beating Q4 earnings estimates. The culprit? Weak forward guidance that signaled struggles ahead, overshadowing past successes.

Management's tone and commentary during earnings calls can also sway stock prices. These calls, typically held immediately after the report's release, allow executives to provide color on the numbers and field questions from analysts. When Elon Musk adopted a contrite tone in Tesla's Q2 2018 call, apologizing for his previous dismissive attitude, it helped reverse negative sentiment despite mixed financial results. Conversely, when Intel's CEO cited "industry-wide component shortages" in a 2021 call, it was seen as deflecting blame, further pressuring the stock.

Industry-specific metrics buried in earnings reports often contain crucial insights. For airlines, Revenue Passenger Miles (RPM) and Cost Per Available Seat Mile (CASM) are vital. When Delta Air Lines reported in Q2 2023 that its CASM had decreased while RPM increased, it signaled improving operational efficiency and demand, propelling the stock higher despite broader travel industry concerns. In biotech, updates on drug trials can eclipse financial metrics; Biogen's stock more than doubled in October 2022 following positive trial results for its Alzheimer's drug, despite muted earnings.

Market sentiment and expectations

The market's reaction to an earnings report is heavily colored by prevailing sentiment and expectations. During the dot-com boom, many tech stocks soared despite posting losses, as investors prioritized growth over profitability. Fast forward to 2022's bear market, and even companies beating estimates saw muted reactions as recession fears dominated. This shift underscores how broader market psychology shapes earnings responses.

"Whisper numbers" — unofficial earnings estimates circulated among professional investors — often set the real bar for companies. These numbers, typically more up-to-date than published analyst estimates, reflect the latest industry scuttlebutt and channel checks. In April 2023, whispers suggested Intel would significantly top official estimates, setting a higher hurdle. When Intel merely met the published consensus, its stock still fell 6%, as it had failed to meet the elevated whisper expectations.

Sector and market-wide expectations also influence individual stock reactions. When banks kicked off Q1 2023 earnings season with strong results, led by JPMorgan Chase's 52%  🔺 profit surge, it boosted the entire financial sector. The strong start fostered optimism that transcended individual reports, lifting even banks that posted more modest results. This dynamic highlights how early reporters can set the tone for their sector peers.

Earnings season dynamics 💸

Earnings season, far from being a series of isolated events, is an interconnected tapestry that unfolds over several weeks. In a typical quarter, it begins with big banks in early-to-mid January, April, July, and October. As an economic bellwether, the banking sector's results can set the market's mood. When Goldman Sachs missed estimates in Q4 2022, citing a dealmaking slump, it cast a pall over growth expectations, affecting sectors far beyond finance.

Different sectors report at different times, creating a cadence to earnings season. Technology often follows finance, with giants like Microsoft and Apple reporting in late January and July. Their outsized market caps mean their results can sway the entire S&P 500. Retail generally comes later, with many companies operating on a fiscal calendar that ends in January, reflecting the holiday season's impact.

This staggered schedule allows for sector rotations as earnings season progresses. Strong results from semiconductor companies like AMD in early 2023, highlighting AI-driven demand, prompted a rotation into tech hardware stocks. Later, when consumer staples companies like Procter & Gamble reported robust earnings despite inflation, it triggered a shift toward defensive sectors as economic concerns mounted.

Early reporters within a sector can significantly influence their peers' stock prices. When United Airlines kicked off the airline earnings in Q2 2023 with better-than-expected results and optimistic commentary about summer travel, it lifted stocks of competitors like American and Delta before they even reported. The phenomenon works in reverse too; 🚚FedEx's dramatic profit warning in September 2022 dragged down the entire transportation sector, as investors extrapolated its global demand concerns.

Summary 💡

• Earnings reports are quarterly financial statements that offer a comprehensive snapshot of a company's health, with metrics like EPS and revenue serving as key indicators that can dramatically sway stock prices.
• The market's reaction to earnings is driven by how actual results compare to analyst expectations, with surprises — both positive and negative — often leading to significant price movements.
• Beyond headline numbers, factors such as forward guidance, management's tone, and industry-specific metrics play a crucial role in shaping investor sentiment.
• Market context heavily influences how earnings are received, with factors like whisper numbers, sector performance, and overall economic concerns setting the stage for individual stock reactions.
• Earnings season is a dynamic, interconnected event where early reporters can set the tone for their sectors, leading to rotations and spillover effects on peers.
• Traders must look beyond individual reports to understand the broader narrative emerging from earnings season, as a company's stock can be significantly impacted by sector-wide trends and market-wide dynamics.
• Mastering the interpretation of earnings reports — from the financials to the subtleties — is essential for traders aiming to capitalize on earnings-driven price swings rather than being caught off guard by them.