What do traders need to know about earnings reports?
An earnings report is a snapshot of a company’s financial health. As Q1 earnings season gets underway in the US, with a slew of new reports to be released, we can look at the ways in which these reports drive trader sentiment and affect the equity markets.
Analysts typically give consensus forecasts of the upcoming earnings reports. If the actual figures in a report exceed the forecast, then the net effect is positive. If the performance of the company lags expectations, the effect on that company’s stock price is typically negative.
Earnings cycles in the US and the UK
In the US, public companies are legally required to report their earnings on a quarterly basis, while in the UK companies report their earnings as they see fit, either quarterly, full-year, or half-year. In any event, the announcement of earnings is followed by a rapid period of reassessment.
An ‘earnings surprise’ occurs when a company’s reported earnings per share, or EPS, differs considerably from the consensus estimate. We talk about a positive earnings surprise when EPS is better than the forecast or a negative earnings surprise when it falls short of the forecast.
Components of an earnings report
Earnings per share (EPS)
EPS allows you to compare the earnings of different public companies. It is calculated as the remaining earnings available to shareholders divided by the number of outstanding shares. In comparing different companies with different EPS, it is important to take the number of outstanding shares into consideration.
Turnover is the total revenue generated by a company during a given period of time. While this gives a headline view of trading activity, turnover may not provide the best indication of a company’s ability to generate income, as it does not take into account the costs required to generate that revenue.
The net income of a company is its final profit after deducting all costs from revenues. Costs include taxes, interest, business expenses and depreciation. In an earnings report, net income reflects the profitability of the company over the stated period of time. In the UK net income is deemed profit attributable to shareholders.
Cash flow is an important determinant of the health of a company. It refers to the cash/cash equivalent that has moved in and out of the company. A positive cash flow is reflective of increasing liquid assets, making it easy for that company to pay off its debts and obligations, provide a buffer in times of uncertainty, and pay shareholders. If the company has low or little cash flow, it is illiquid and that is problematic for normal day-to-day functioning.
Why are dividends important?
Dividends are cash distributions made to shareholders from earnings, a clear indication of the financial health of a company. A company that pays increasing dividends is viewed positively, and investors with stock holdings appreciate these payouts whenever companies decide to make them. The dividend yield is calculated as the yearly dividend income per share divided by the prevailing share price.
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