Earnings Report Catalysts

Predicting the way a stock will move on earnings is a dark art. It can be frustrating because a company turns in a clean report, only to have the stock dump after they report. So what drives a stock to move on earnings?

To borrow a line from the movie "My Cousin Vinny", an earnings report is like a house of cards, built by management to communicate how they are a healthy, functioning business. There are several metrics on which the company must perform well, or the house (stock price) might collapse.

Aggressive Revenue Growth

When a company grows its quarterly revenue up unexpectedly, it gets investors' attention. A recent example is Nvidia, which was beating on all metrics to fuel its post earnings report runs. However, its impressive revenue growth grabbed headlines and stoked the excitement around its earnings. Another common metric to monitor is a stock's "average revenue per user" or ARPU.

Earnings Per Share Beat

Earnings per share is one of the most common metrics that gets scrutinized, hand in hand with revenue. It is a cornerstone of the "house" built by management.

Reinvesting to Grow Future Profits

It's bullish when a company announces investments in itself to set up for future growth. For example, while Toyota is dominating the hybrid vehicle market, they're making plans for the future by building factories to address the electric vehicle market. By diversifying into different segments, they're setting up for more growth in the future. A loosely related metric is CAGR, or compound annual growth rate tracks a company's ability to compound growth. A company that reinvests in itself will likely have a stronger CAGR, which investors love.

Impressive Free Cash Flow

Investors love to talk about a company's free cash flow. This is how much cash a business has after accounting for operating expenses, capital expenditures, and taxes. This is the cash leftover that a business can use for dividends, paying debt or reinvesting in the business.

Declaring a Dividend

When a company declares a dividend unexpectedly or has an ongoing reputation as a "dividend aristocrat" they tend to hold more favor with investors. However, be aware of the trade-off the business is making between dividends and reinvesting the money in the business itself. Ultimately, the purpose of any business is to return value to shareholders and this is one way to explicitly achieve it.

Stock Buybacks

Similarly, stock buybacks are another way to return value to shareholders. A large stock buyback can appease investors because it is capital the company allocates directly to raising the stock price. This is money the company could be using elsewhere but it is common practice to buy back your own stock occasionally to return value to shareholders.

Growing Sales Rapidly

The profits of most companies can be traced back to its ability to sell its products. Sales is another metric that investors keep an eye on to see the health of the business. When sales are exploding, so does the stock price. However, sales are only a piece of the house. Growing sales is less impressive if the COGS (Cost of Goods Sold) is offsetting those gains.

Profit Margin

Tesla is an example of a company that has emphasis on its margin on each car it sells. The higher margin they can achieve on each vehicle produced, the more money they're making per car. Higher profit margin means more profit for the company's output.

Profitable Business

In a bull market, investors have a higher risk appetite for companies that are unprofitable. Spotify is an example of a company teetering on the edge of profitability. In Q3 2023, they reported a profitable quarter for the first time in a year. After earnings, the stock ran up +10%. It's looking promising for them to reach profitability but there is more risk waiting for that to happen than to own a business that's already profitable. However, if you get in before a business turns profitable and they succeed, you'll reap more gains.

Partnerships

Disney recently announced an unexpected partnership with Epic Games. They are investing $1.5 billion for a stake in Epic. It could be a source of growth down the road that is not yet baked into the stock price. Epic has Fortnite, the most popular video game in recent years and a strong community behind it that could spur growth for Disney. Likewise, Microsoft gained extra wind in its sails due to its partnership investing $10 billion in OpenAI. On top of that, they can integrate OpenAI's ChatGPT into their product suite and Bing search engine. This shows how strategic partnerships can give a company a shot in the arm.

Forward Guidance Raised for Key Metrics

Guidance can sway the sentiment of investors. Beating the guidance for earnings per share and revenue is generally seen as positive. The context of the guidance from the company management is important. Did they give soft guidance becuase of unseen supply chain issues or macroeconomic conditions? If so, beating the guidance means less. When the guidance is strong and the company "beats and raises" guidance, it's bullish for a stock. Giving soft guidance in order to smash future reports is also known as "sandbagging". You need to be vigilant to make sure the company you own is not sandbagging its guidance.

Industry Key Performance Indicator

In Q3 2023, Google turned in a seemingly solid report. However, the stock went -10% after earnings. Why? From reading sentiment online, the stock went down because the company missed their guidance on cloud growth. The cloud growth metric has an outsized impact on Google's earnings. In that quarter, they were penalized for missing. For social media or gaming platforms, monthly active users (MAUs) have outsized importance.

Management Shake-up

This catalyst can be positive or negative, depending on the perceived state of the current management. Positions like the CEO, Chief Executive Officer, have outsized importance in the management of the company. If investors think the CEO is valuable to the company, the news that they are stepping down can drive the stock down. Conversely, if a CEO is perceived as weak, bringing in a new CEO can be a positive catalyst.

Catalysts Already Priced Into the Stock

Sometimes, all the good news is priced in. Stocks with momentum tend to run up heading into an earnings report in anticipation. If the report underwhelms and doesn't show any new catalysts, the stock price may deflate after earnings.

Conclusion

With some luck and skill, the "houses" you own will have strong foundations that will sustain growing income for many years. These are some things to watch for when a company you own reports earnings. It is seemingly impossible to understand why a stock moons or tanks after earnings, good luck!

Disclosure: Not financial advice. The author holds stock in the companies mentioned.