Earnings Reports: How Can They Serve You in Your Trading?
An earnings report is a quarterly or annual publication released by a public company, outlining how much the company profited or lost and the sources of such income, and how monies were spent during the period under review.
In many jurisdictions (including the US), public companies are legally bound to release earnings reports quarterly, meaning that four reports are supposed to be released every year. The first quarter ends in March, Q2 ends in June, Q3 ends in September, and Q4 runs until December.
The basic structure of such a report consists of a balance sheet outlining expenditure, a cash flow statement, and an income statement outlining how earnings were generated.
The earnings season typically starts within the first 14 days after the end of the previous quarter. As much as earnings reports provide a lot of information on a company’s performance, investors are usually most interested in earnings per share (EPS), which is the actual return on investment. EPS is the measure of how profitable a company is.
The principal consideration for investors in these reports is the number of profits generated by companies. Naturally, a company that announces losses isn't as attractive to investors as making profits.
Employing earnings reports in trading
The economic calendar outlines critical dates for announcing the productivity and performance of the economy and companies. The release of earnings reports is among the most anticipated events on the economic calendar.
Economic analysts evaluate a company's performance in detail, and in the end, they can forecast their projections on the potential earnings of the company weeks before the official announcement. Analysts usually give their projections in terms of EPS.
After the release of EPS projections, the company's stocks usually react to the news depending on whether the projections are above or below the previous earnings. Investors will be quick to buy more of the company's stock if analysts project a rise in EPS. Conversely, they will go short when the EPS projections are unimpressive.
While analysts' projections significantly affect stock price movements, the biggest price action occurs after the release of earnings reports. The bigger the margin between the projected EPS figures and the actual earnings reported figures, the bigger the changes to the company’s stock price.
However, there are situations whereby investors may have brought the stock in large quantities in anticipation of strong EPS figures. In such instances, the release of an earnings report may be followed by a sell-off, even if the reported figures are good. This is because investors may have already gained from the good EPS figures and believe that further gains are slow.
Tips on profitable trading of earnings reports
Study the stock's price movement two or even three weeks before and after analyst estimates become public. If you notice that the price rose significantly after the release of the data, you should consider selling the stock upon the release of the earnings report. However, if the price plummeted after the release of the projections, you should prepare to buy the stock after the release of the earnings report.
Look at the price action in previous months after the release of the earnings report.
Use the Relative Strength Index (RSI) to guide you on whether the stock has been oversold (below 30) or overbought (above 70). A high RSI is an indication that the price is likely to appreciate. On the other hand, an overbought stock may soon experience increased shorting.
Assess the coverage received by the company in recent times. If the company's stock is excessively hyped as the hottest investment, then there's a risk that it is overvalued. Similarly, if the stock has strong fundamentals but is rarely mentioned, then it is potentially undervalued and may rise soon after the release of the earnings report.
You can make good returns on such releases both as a day and swing trader. Alternatively, you can look for stocks that have recently lost their value in the period after the reports were published. This will allow you to buy high-value stocks at a "discount.” The key thing is to evaluate the company's key statistics to know whether they are likely to gain value in the coming days.
Strategies for trading earnings reports
1. Put the earnings calendar to good use: You should identify 3-5 stocks that plummeted for no other reason except disappointing earnings reports. As highlighted above, some stocks are "unfairly" dumped by investors after the release of earnings reports, despite having strong fundamentals. Such stocks have high growth potential.
2. Know how to identify stocks that have strong growth prospects: You should carefully look at stocks that fell after earnings reports but are on the recovery path. You should study their recovery patterns in the past periods. This will give you a better understanding of the likelihood of those stocks returning a profit before the next projected earnings are released.
3. Study stock history: This is one of the most overlooked strategies in trading earnings. Analysts often miss the mark in projecting earnings. As an investor, stocks whose earnings have frequently performed better than projections are a gold mine. You should find such stocks and buy them after projections but before earnings reports.
Such stocks are likely to appreciate after the earnings reports are released, number and you can therefore sell them at a profit. However, make sure that you do not put all your hopes on history, but do your due diligence and analyze the stocks for their strengths and weaknesses.
Earnings reports are great tools for decision-making on whether to buy or sell a stock. You can optimize their potential by combining them with an analysis of the stock's recent performance and analysts' projections. Importantly, ensure that you incorporate the prevailing fundamentals and technical metrics in your analysis.
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