How do quarterly earnings reports affect stock prices?

Its earnings season once again and the market has been moving quite volatile lately as investors react to first quarter earnings announcement by listed companies.

Quarterly earnings reports are important financial updates that provide a market glimpse on how stocks will likely be valued in the future. Stock prices tend to rise when earnings results exceed market expectations while disappointing earnings results tend to lower share prices.

Stock prices move based on market expectations. A 20-percent increase in quarterly income may not be seen as positive if market expectation is 40 percent. In the same way, a 10 percent decrease in earnings may cause a stock to go up if the expectation is a much larger decline.

Market expectations

In absence of market expectations, there is little correlation between stock prices and earnings growth results. Based on statistical data, the correlation between historical three day returns of the 30 stocks in the PSE index and the results of first quarter earnings announcement is only 12.8 percent.

However, when we add the element of market expectations so that stock prices would fall as a result of disappointing earnings results, the correlation improves significantly to 41 percent. Stocks that failed to meet market expectations lost an average of 1 percent in three days while those that succeed gained an average returns of 3.12 percent.

But how do you measure market expectations? Stock brokers normally use consensus of earnings estimates made by research analysts in the market, where the median estimate becomes the basis for comparison. When you don’t have access to different analysts’ forecast, you can also use earnings guidance from listed companies to estimate your own target.

Earnings game

While quarterly earnings results evoke market reactions, any negative impact on stock prices is mostly short-term. Using the same set of historical data in this exercise, the stocks that lost value in three days, as a result of negative market response, eventually recovered after 30 days with an average return of 6.14 percent.

Following this historical behavior, you can take advantage of the current volatility in the market by playing the earnings game. Just because some stocks tumbled due to disappointing earnings doesn’t mean that they are not good investment anymore. In fact, they can be an attractive buying opportunity for as long as the fundamentals remain sound.

For example, one stock that is worth looking at the moment is Universal Robina Corp. (URC), whose share price has fallen recently by 9 percent after it reported 4.2 percent decline in net income for the first quarter. The top line news may be bad but when you look beyond the earnings, you will see that sales continue to grow in almost all market segments by an average of 8 percent. With fundamentals remaining solid, expect the stock to rebound soon as the company adjusts to perform better in the next quarter.

Market reactions

Another way to play this game is to trade stocks that are often followed by institutional investors, who are highly sensitive to quarterly earnings reports. In a simple regression modelling exercise, we find that the movement of stocks with market capitalization of at least P95 billion have high correlation of 54.6 percent with earnings announcements while stocks with P60 billion and below have correlation of only 23 percent.

This shows that market reactions to earnings report are stronger at companies with bigger market capitalization because institutional investors, when they react to surprises, can dictate the short-term direction of any stock due to the sheer size of their investments.

Some of the big cap stocks whose earnings reports are historically susceptible to market reactions are SM Investments, Ayala Land, SM Prime, JG Summit, BDO Unibank, Ayala Corp., Aboitiz Equity Ventures, BPI, PLDT, Universal Robina, Metrobank, GT Capital, ICTSI and Jollibee.

Knowing the historical tendencies of these stocks can help you anticipate possible earnings surprises, trade on positive news and make short-term gains in few days.

Earnings momentum

It always pays to research stocks that report significant quarterly earnings growth because this can possibly lead to more earnings surprises in the subsequent quarters.

While negative market reactions from earnings report can affect stock prices on short-term basis, positive earnings surprises can help you identify potential stocks to invest for the long-term.