Latepost Turn A Profit Surprises, Cost Reaction In Addition To Value

The earnings flavor is upon us too each company’s earnings annunciation is eagerly awaited, traded upon too talked about. For widely followed companies similar Apple, the obsession amongst what the adjacent earnings written report volition deliver overwhelms whatsoever sensible assessment of what it way for the company. But is this obsession merited? Do earnings announcements conduct maintain pregnant effects on value? If so, why? More importantly, tin give the sack y'all make money off earnings announcements? 

The “Announcement” Process
To sympathize how too why earnings reports matter, nosotros should start past times looking at the process. Publicly traded companies are required to written report on their functioning at “regular” intervals. In the US, the reports conduct maintain to come upward every quarter, amongst amount fiscal statements filed amongst the SEC. The grade of disclosure varies across markets, both on timing (quarterly, semi-annual too annual) too on data (partial reports of functioning inward some regimes).

The reporting ritual is highly scripted, at to the lowest degree inward the US, inward terms of timing (companies written report earnings on virtually the same appointment every year, give or conduct maintain weekends, too inward the same format to allow for yr to yr comparisons). The initial written report provides the bare os details (revenue growth, earnings per part too a breakdown of a few extraordinary items) too is followed a few weeks afterwards past times the amount filing of the quarterly written report (10Q) amongst the SEC.

Since earnings reports contain data that tin give the sack touching on prices, the SEC does regulate trading too disclosure around the reports. Insiders are restricted from trading earlier earnings announcements too Regulation FD bars firms from providing data virtually upcoming earnings reports to subsets of investors (analysts). In theory, at least, the data inward an earnings written report should live “news” to markets.

Companies may live restricted from providing data selectively to analysts next them, but this does non preclude analysts from forming too propagating their expectations virtually what the earnings written report volition contain to their clients and, past times extension, the public. In fact, a substantial portion of a typical equity inquiry analyst’s fourth dimension is spent on the “earnings forecasting” exercise, too at that topographic point are services that assess analyst character past times looking at how unopen the forecast comes to actual numbers. In the US, services such every bit Zacks too I/B/E/S that rails too written report analyst forecasts of earnings too y'all tin give the sack notice them inward the populace domain (Yahoo! Finance or similar sites)

The Expectation Game
When a society does written report its earnings, markets volition react to the “news” inward the written report but the way nosotros stair out the word has to live relative to expectations. Thus, a society that reports that its earnings went upward past times 30% may live seen every bit delivering bad news, if investors were expecting an growth of 40%, too a theatre that announces an earnings reject of 30% may live providing positive information, if the expectation was that earnings would reject past times 40%. Thus, it is non the magnitude of the earnings alter that thing but the “surprise” inward the earnings, measured every bit the earnings alter relative to expectations.

But how do y'all stair out expectations? One obvious respond is to locomote the analyst estimates of the earnings too word reports similar this 1 by too large compare the earnings alter to the “consensus” gauge of earnings alter to frame the report. Influenza A virus subtype H5N1 2nd is to locomote the “past” earnings growth for the society every bit a stair out of expected earnings growth. With either measure, then, a positive (negative) earnings surprise too so becomes an earnings written report where the actual earnings per part exceeds (falls below) the expected value (using consensus earnings estimates or historical earnings growth).

While y'all tin give the sack locomote analysts or history every bit the footing for estimating expected earnings, the marketplace position expectations procedure is a to a greater extent than nuanced 1 too to a greater extent than hard to model. In the lastly ii decades, firms conduct maintain locomote to a greater extent than attuned to playing the earnings game, too conduct maintain locomote increasingly expert at beating earnings expectations past times playing both sides of the game. First, they piece of work on analyst expectations, using selective leaks to choose expectations down, prior to earnings reports. Second, they piece of work to mold the actual earnings, using both accounting choices (earnings management) too operating discretion (timing of R&D expenses, for instance) to deliver results that trounce expectations. The work amongst this game is that markets choose handgrip of on too adjust expectations accordingly.

The Announcement Effect
If y'all tin give the sack stair out earnings expectations, an earnings surprise should conduct maintain an outcome on stock prices, amongst positive (negative) surprises evoking positive (negative) responses. The earliest studies of earnings surprises used historical earnings to gauge expected earnings too establish backing for this hypothesis. In to a greater extent than recent studies, consensus estimates of earnings conduct maintain been used to stair out expected earnings. The next graph captures the annunciation outcome of earnings surprises, categorized from most positive to most negative, amongst expectations measured every bit consensus gauge from analysts:

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There are 3 interesting findings embedded inward this graph. 

1. Pre-announcement drift: There is a mild drift inward stock prices earlier earnings reports that is consistent amongst the eventual surprise: prices motion upward earlier positive surprises too downwards earlier negative surprises. I volition permit y'all brand the judgment on whether this is bear witness of insider trading, investor prescience or some combination of the two. 
2. Announcement effect: The annunciation all the same contains news. On the announcement, the cost outcome reflects the magnitude too the administration of the surprise, amongst stock prices going upward virtually 3%, on average, inward reaction to the most positive surprises.
3. Post-announcement drift: The most surprising finding is that stock prices locomote along to drift after the annunciation inward response to the surprise. The graph below looks at the cost drift inward the xxx days after the announcement:

Differences across firms
There are studies that dot that the returns associated amongst earnings surprises are to a greater extent than pronounced amongst some types of stocks than amongst others. For instance,

1. A study of value too growth stocks found, instance, that the returns inward the 3 days around earnings announcements were much to a greater extent than positive for value stocks (defined every bit depression PE too PBV stocks) than for growth stocks across all earnings announcements – positive every bit good every bit negative. This suggests that y'all are much to a greater extent than probable to larn a positive surprise amongst a value stock than amongst a growth stock, indicating perchance that markets tend to live overly optimistic inward their expectations for growth companies. 
2. Earnings announcements made past times smaller firms seem to conduct maintain a larger impact on stock prices on the annunciation appointment too prices are to a greater extent than probable to drift after the announcement. 
3. As amongst analyst reports, at that topographic point seems to live bear witness that the marketplace position reaction to earnings reports is a business office non solely of the earnings position out reported but too the accompanying administration commentary.
4. There is some bear witness that the marketplace position reaction to earnings reports is greater at firms amongst high institutional ownership, amongst 1 rationale beingness offered that institutional investors tend to live to a greater extent than curt term inward their focus too hence to a greater extent than probable to respond to quarterly earnings reports.

There is 1 lastly aspect of the earnings game that may live affecting stock marketplace position reactions. As firms locomote expert at playing the game, managing expectations too tweaking earnings to trounce expectations, investors conduct maintain adapted. Firms that consistently trounce consensus estimates at in 1 lawsuit conduct maintain to trounce them past times a "margin" (based upon their past times history) to register a positive surprise. This is of course of teaching the phenomenon of "whispered earnings". With the Apple annunciation due afterwards today (July 24, 2012), the consensus earnings gauge is for earnings per part of $10.35 too the whispered earnings gauge is 67 cents higher at $11.02. The solely work is that Apple has beaten whispered earnings 42 out of the lastly 56 quarters. It is solely a thing of time, I guess, earlier y'all conduct maintain whispers on top of whispered earnings. My caput hurts but thinking virtually the possibilities.

Playing the Earnings Game
So, how tin give the sack investors play the earnings game? Using the earnings surprise graph every bit the footing for the discussion, hither are some of the possible paths.
a. Predict the surprise: You tin give the sack endeavor to devise ways of forecasting positive or negative surprises earlier they occur. I know it is easier said than done, but to the extent that y'all tin give the sack remain on the correct side of the insider trading police too notice advance indicators of upcoming surprises (trading book changes, cost patterns etc.) y'all tin give the sack profit.
b. Trade on the news: To conduct maintain payoff of the drift after the news, y'all could purchase stocks after exceptionally positive earnings announcements too sell curt on stocks after terrible earnings reports. Given that the drift is virtually 2-3%, don't aspect this to do much to a greater extent than than augment returns at the margin. You could of course of teaching charge upward too locomote options to leverage the profits, but...

c. Play the earnings momentum game: While the kickoff ii strategies are curt term, at that topographic point is a longer term strategy that tin give the sack live built around earnings reports. Studies dot that companies that conduct maintain consistently trounce earnings reports over the lastly few quarters deliver higher returns inward subsequent periods. Thus, inward add-on to screening for high character growth too depression risk, y'all tin give the sack too concealment for earnings momentum.
d. Intrinsic value assessment: As a believer inward intrinsic valuation, I aspect for ways to necktie the data inward earnings reports to intrinsic value. To do that, though, y'all need to aspect past times the top draw of piece of work word (earnings per share) too at the underlying details (revenue growth, operating margins too render on capital). If y'all do so, y'all may really good notice  a written report that looks positive on the surface (because the actual earnings overstep expectations) but contains plenty negative word (lower revenue growth, declining margins too render on capitals) to crusade intrinsic value to decrease. If the marketplace position misreads the written report every bit "good" word too the stock cost jumps up, y'all conduct maintain the makings for a contrarian play.

So, hither is the challenge. By the fourth dimension y'all read this post, the Apple earnings written report volition conduct maintain been made public. Evaluate it too brand your judgment on how (if at all) y'all volition contain it into your investment strategy for Apple. I conduct maintain attached my intrinsic valuation of Apple (made earlier the earnings written report came out) with suggestions on how to contain the data inward the earnings written report into value. Take your best shot!

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