Latepost Reacting To Profits Reports: Pricing Metrics Together With Marketplace Reactions

In my terminal post, I looked at how earnings reports too other word stories almost a society incorporate information that tin atomic number 82 y'all to reassess your narrative too consequently the value that y'all attach to that company. If y'all are an investor or analyst who is familiar amongst how markets react to earnings reports, y'all tin legitimately fighting that I am making this procedure to a greater extent than complicated than it has to move too that what y'all encounter at the fourth dimension of the earnings study is a marketplace reaction to how good or badly companies deliver on a specific pricing metric, relative to expectations. You are correct too inward this post, I volition human face at why investors frequently focus on these uncomplicated (and sometimes simplistic) metrics, how these metrics tin alter every bit a purpose of where a society is inward its life wheel too  the dangers of focusing on metrics rather than value.

The Allure of Price Metrics

As y'all scout investors react, sometime violently, to a society reporting earnings per portion that are a few cents below or higher upwards expectations, y'all may wonder why so much attending is beingness paid to a unmarried metric too so niggling to the residue of the word inward the earnings report. While I intend the do is dangerous, it tin move explained amongst the following:

1. It is easier to focus on a unmarried release or metric than it is to railroad train a narrative too a valuation for a company. Consequently, investors too many analysts prefer to pass almost all of their fourth dimension inward coming upwards amongst estimates for that number, on the supposition that if they are correct almost those estimates, neither narratives nor valuations matter.
2. In several before posts, including these on Apple too Twitter, I convey drawn a distinction betwixt value too toll too argued that piece investors attention almost the former, traders are much interested inward the latter. If y'all are a trader, it makes consummate feel to non solely honor the metric that other traders are using to justice companies (even if that metric is a weak mensurate of value too dependent area to manipulation) but to brand estimating that metric the catch of your investment strategy.

It is for this ground that I telephone phone this the "earnings game", where analysts too investors course of study expectations almost a metric (earnings per share, revenues, release of users/subscribers), companies elbow grease to deliver actual numbers that crunch these expectations too markets too so react to the reports. I describe the procedure inward exceptional inward this post, amongst the aggregate evidence on both the marketplace reaction to earnings reports every bit good every bit the post-report toll adjustment process.

Pricing Metrics too the Corporate Life Cycle

While it is truthful that the predominant metric used to justice a society is earnings per share, investors sometimes exercise other metrics, with Alibaba willing to pay $10 billion for them). With Twitter, Linkedin too Yelp, investors seem to move making a transition, where revenues are clearly part of the equation, fifty-fifty though the release of users is withal a cardinal number. With Google too Apple, companies amongst established line of piece of job concern models, revenue increase is a consideration but earnings clearly dominate.   

The Dangers of Pricing Metrics

While it is slow to encounter why investors focus on i or ii metrics, when touchstone society performance, the dangers of using these brusque cuts are manifold:

1. Missing the residue of the story: The value of a line of piece of job concern is driven yesteryear many determinants, including its capacity to generate profits (and cash flows) from existing assets, the expected increase charge per unit of measurement inward these earnings & the efficiency amongst which this increase is delivered too the opportunity inward futurity cash flows. No unmarried metric volition ever capture all of these factors, too inward using whatever metric (number of users, revenues, earnings), y'all are inward outcome assuming that everything else that drives value remains unchanged. To illustrate, a society that reports higher earnings per portion but does so because it has entered riskier businesses, may encounter its stock toll jump on the earnings report, fifty-fifty though its value has dropped.
2. Tunnel vision: It is natural to railroad train tunnel vision, when your focus narrows. Investors too analysts who pass all of their fourth dimension too resources refining their estimates of i or ii metrics, whether they move revenues or release of users, volition shortly attention merely almost those numbers too ignore the residue of the information (and story). 
3. Game Playing: Once companies recognize that investors are focused on i or ii metrics, it is natural for them to play the game every bit well. Thus, if analysts are unduly focused on earnings per share, companies volition play accounting games to brand their earnings per portion human face improve than they should. I argued that the market's focus on the release of users at social media companies best explained why Facebook would pay $19 billion for Whatsapp. 
4. Transition Phases: As the life wheel motion-picture present illustrated, investor focus does alter every bit a society moves through the life cycle. It is thus a given that at merely about indicate inward time, every bit social media companies evolve too grow, investors volition halt looking at the user base of operations too focus get-go on user appointment amongst line of piece of job concern models (revenues) too and so on the profitability of these models (earnings). However, these transitions are unpredictable, too when they do occur, companies that intend that they are playing yesteryear marketplace rules (delivering to a greater extent than users than markets expected) may move shocked to discovery that the rules convey changed (and that they are beingness punished for losing money). 

The Bottom Line

To play the earnings study game, if y'all are a trader, y'all convey to move able to both pinpoint the metric that markets volition react to (which may non e'er move the metric that analysts next the society are focusing on) too move improve at estimating how the society volition do on that metric than other investors. If y'all tin play that game well, it is a lucrative i but it is too risky, since seismic shifts tin occur from quarter to quarter. That is why it may behoove traders to empathize the narrative/value procedure described inward my terminal post, fifty-fifty if they select non to invest based upon that process.

Links

1. Earnings Surprises, Price Reaction too Value
2. Winning (losing) yesteryear losing (winning): The Power of Expectations
3. Reacting to Earnings Reports: Narrative Adjustments to Value
4. Reacting to Earnings Reports: Pricing Metrics too Market Reaction
5. Reacting to Earnings Reports: Let's become real!

Tweet

Subscribe to receive free email updates: