This earnings season is almost behind us, but it won't be long before another starts up again, and the quarterly obsession with earnings reports begins anew. Firms will see their market values increase or decrease by billions of dollars because they miss, match, or beat analysts' earnings estimates. But is this reaction warranted? Does an earnings announcement contain that much information?
Let us begin with the second question first. Quarterly and annual earnings reports are the most informative documents a firm provides to financial markets, but analysts and investors' focus on earnings per share often obscures these reports' more important news. Four pieces of information in every earnings report have relevance for value (and, by extension, for stock prices):
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How well is the firm managing its existing investments and assets? Earnings and cash generated during the accounting period (quarter or year) covered by the earnings report measure how efficiently the firm put existing assets to use.
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What is the firm's growth potential? Growth in earnings, cash flows, and (most importantly) revenues over prior periods all signal whether the overall market for the firm's products is expanding, stagnating, or contracting.
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Are the firm's competitive advantages holding up, decreasing, or being augmented? Margins and returns on capital indicate how the firm's competition is shaping up, and whether the firm's competitive advantages are strengthening or weakening.
- What is the firm's cost of financing its operations? Costs of financing come from both debt and equity, with interest expenses representing the former and dividends and stock buybacks composing the latter. The implicit cost of equity is generally much higher.
The answers to each of these questions affect the value of the firm, but the relative importance will vary across firms. For mature firms like Alcoa (NYSE:AA), with minimal growth opportunities and little or no excess returns, the assessment of past earnings will be the most significant part of the report. For growing firms, though, it is likely that the information about growth and margins will be far more significant. For these firms, the focus on earnings per share and meeting analyst expectations is dangerous; much of these companies' value comes from future growth potential. Thus, firms like Google (NASDAQ:GOOG) or Apple (NASDAQ:AAPL) may beat earnings estimates but still see their values decrease, because the report contains bad news about margins and returns on capital.
If we consider information in all of its dimensions, not just in terms of earnings per share and expectations, it is easy to see why an earnings report with a small earnings surprise can still have a large impact on the value of a company. In fact, the more a firm's value comes from future growth prospects, the greater the likely impact of its earnings reports.
This does not mean that the market reaction to earnings reports is always rational and proportional. The initial reaction to an earnings report, based as it is on the narrow measure of whether the actual earnings per share is higher or lower than analyst expectations, can often be wrong. It is more likely to be incorrect for young growth companies than for mature firms. These mistakes offer opportunities for investors who take the time to look past the earnings numbers to the underlying fundamentals.
Fool contributor Aswath Damodaran is a professor of finance at the Stern School of Business at New York University. An enthusiastic teacher who has been voted Professor of the Year by the graduating MBA class five times during his career at NYU, Professor Damodaran also provides a wealth of outstanding content on his website. Among his numerous books, Fools might be interested in Investment Fables and Investment Valuation . He holds a long position in Apple and a short position in Google but holds no financial position in any other stocks mentioned. The Fool has a disclosure policy.
