Understanding Earnings Season
Quarterly earnings might seem strange. But they're important nonetheless
On their face, corporate earnings reports are a bit weird. Stocks can make enormous moves because their performance over a single, three-month period disappoints Wall Street — or sometimes, even when results are better than analysts expect.
It seems not only weird, but counterproductive. After all, the most common investing wisdom from the likes of Warren Buffett and other great investors is to buy and hold great businesses for the long term. And it hardly seems like a great idea for the businesses themselves to run their operations with a focus on single quarters as opposed to multiple years.
Indeed, in Europe, a six-month reporting period is much more common (though large and/or U.S.-listed companies still provide quarterly updates). And in the U.S., well-known industry participants have on occasion suggested the domestic market copy the structure on the Continent.
In 2018, then-President Donald Trump asked the U.S. Securities and Exchange Commission to evaluate semi-annual reporting. That same year, Tesla TSLA 0.00%↑ chief executive officer Elon Musk floated the idea of taking his company private. In an email to employees, Musk spoke directly to the idea that quarterly reporting leads to a focus on short-term thinking:
Being public also subjects us to the quarterly earnings cycle that puts enormous pressure on Tesla to make decisions that may be right for a given quarter, but not necessarily right for the long-term.
Before and since, academics and corporate executives — and even a few investors — have made similar arguments. Yet quarterly earnings remain.
We believe that’s a good thing. But our personal opinions aside, investors have to deal with the world as it is, not as they think it should be. And understanding why earnings matter, why they move stocks and even why (and how) they can lead to overreactions is a key part of understanding the investing world.
What “Consensus” Means
Particularly during ‘earnings season’ — which runs, roughly speaking, 15 to 35 days following the end of a calendar quarter1 — the focus of the financial media seems to focus intently on whether a company “beats” or “misses” with its earnings report.
It’s worth taking a step back to understand exactly what a “beat” or a “miss” means. Sell-side analysts2 — ranging from giants like Goldman Sachs and JPMorgan Chase to smaller outfits of which many individual investors are unaware — publish their estimates of revenue and earnings per share3 in the quarter. The average of those estimates is referred to as the consensus estimate. When the company reports earnings, its actual revenue and earnings per share are compared to the respective consensus estimates. If actual results are better than estimates, the company “beat” consensus; if they’re worse, the company “missed”. And if the company goes one-for-two (for example, beating revenue and missing on EPS), earnings are referred to as “mixed”.
That description alone gets to one of the core complaints about quarterly earnings: who, exactly, put analysts in charge? It’s not uncommon to hear investors gripe that if a company “misses” earnings, it wasn’t the company that missed; rather, it was Wall Street that got it wrong.
It’s a somewhat fair complaint — but it also misses the point. Consensus estimates are a guidepost, but investors absolutely make up their own minds. Indeed, before a report, institutional investors in particular may have a so-called “whisper number”, a more up-to-date forecast. But that aside, one thing to absolutely keep in mind is that just because a company beats earnings, that does not mean the stock goes up.
This is a fact that often causes confusion for inexperienced investors. There is a sense in which if a company “beats”, the stock should go up, and if it “misses” the stock should go down. That sense, on its face, has some logic behind it: if the company is performing better than Wall Street expects, then the stock should go up after earnings.
BILL Plunges
But that’s not how it works — for a few reasons. Again, investors make up their own minds. More importantly, however, is that stock prices react most directly to what is going to happen in the future, not what has happened in the past. Backwards-looking results are useful in trying to forecast future results, but on their own have exceptionally little value. If, for instance, a company’s earnings are 10 cents better than expected, but the long-term outlook remains unchanged4, the stock price should be 10 cents higher. No more, no less.
In that context, the absolute worst-case scenario for a stock is if the company beats estimates for the prior quarter, but provides its own outlook that misses estimates for the next quarter, or even worse the full year. The good news is looking backwards; the bad news is looking forwards. Again, the market (wisely) places much more emphasis on the latter.
In this earnings season, we have a perfect example of this phenomenon. On Thursday, after the market closed, bill payment provider Bill Holdings BILL 0.00%↑ reported earnings for the third quarter. Relative to consensus expectations, Bill.com had a solid quarter: adjusted EPS of 54 cents was 4 cents better than the Street anticipated, and revenue growth was about two percentage points higher than sell-side analysts expected.
The next day, BILL stock plunged 25%. The problem was that the company cut its full-year guidance. Following the fiscal fourth quarter release in mid-August, the midpoint of guidance suggested revenue of $1.30 billion, and adjusted EPS of $1.895. After Q1, the full-year outlook dropped to $1.23 billion, with EPS falling to $1.815.
Source: Koyfin
Those moves don’t sound like much, admittedly. But bear in mind that the cut came after a fiscal Q1 which was better than not only analysts, but the company itself, forecast. Both revenue and earnings per share for fiscal Q1 were better than even the high end of the company’s guidance range5.
If you do the math, then, the market’s expectations for the last three quarters of fiscal 2024 plunged dramatically. By the company’s reckoning following the Q4 release, revenue from Q2 through Q4 of fiscal 2024 was supposed to be right at $1 billion. Following the quarter, implied guidance was $920 million. Adjusted EPS was forecast — again, by the company itself — at $1.40 over the last three quarters of the fiscal year. After Q1, the same math suggested implied EPS guidance of $1.2656.
Now, an investor could argue that a roughly 10% decline in expected earnings over the next three quarters doesn’t support a 25% decline in the stock price. But in fact, that kind of reaction is completely logical. What Bill Holdings itself is saying is that its profit growth over the next nine months is going to be lower than it expected. That matters — enormously. Setting aside the debate over whether management believes performance over the next three quarters is just a ‘speed bump’ (and investors should not take management 100% at its word), from a purely mathematical perspective that outlook should have a significant impact on the value of the stock.
After all, what matters for a stock is not what earnings are right now, but what earnings will be in the future. Indeed, for every stock, its valuation is essentially an argument over what its earnings will be in the future. And if Bill Holdings itself thinks its near-term earnings will be lower, that in turn means that its long-term profits, too, will be lower. In other words, if investors expected Bill could increase earnings 10% a year off the fiscal 2024 base, then the fact that this year’s base is lower has effects that last long into the future. Unless management can convince the market that the next few quarters are simply an anomaly — and Bill management clearly didn’t — then a 25% decline off a 10% ‘miss’ in earnings over just three quarters makes perfect sense.
It’s Not Just The Numbers
After the market closed on Wednesday, Confluent CFLT 0.00%↑, a provider of data analysis software, released earnings for the third quarter. Q3 looked fine, and perhaps even impressive. The company posted a surprise adjusted profit of 2 cents per share against the consensus estimate for a 1 cent per share loss. Revenue of $200 million was $5 million better than the average Wall Street estimate — and in the context of a single quarter, a 2.5% beat is not something to sneeze at.
The next day, Confluent stock plunged 42%. But, in this case, the overall numbers seemed reasonably solid. The company’s outlook for fourth quarter revenue missed only by a couple million dollars. Purely in terms of the math, nothing suggested such a sharp plunge, which took roughly $3.5 billion off the company’s market capitalization.
Source: Koyfin
In terms of the basic math, the plunge in BILL perhaps makes some sense. A shortfall relative to near-term expectations leads to an exaggerated long-term impact. But Confluent’s outlook for the entire year was pretty much in line with Wall Street expectations. And yet the stock was still crushed.
The issue here, however, is one that isn’t apparent just using basic math. On the earnings conference call, Confluent management admitted that two major customers were bringing their software workloads back ‘on-premise’ (in other words, onto local servers) instead of running them through the cloud offerings provided by Confluent.
Admittedly, it seems close to insane that investors would react so violently to such a data point. And CLFT’s plunge in turn would seem to be a buying opportunity. Some investors certainly saw it that way: the stock did gain 9% the session after the 42% plunge.
But, taking a step back from the numbers, the market’s caution does make at least some sense. If Confluent’s biggest customers are pulling data in-house, surely that’s a negative sign for the rest of the business. And if the value proposition here is not so compelling as to preclude such a change, then perhaps the pre-earnings valuation was simply wrong, because the underlying business here is not as attractive as investors believed. If that’s the case, then a 25% reduction on the stock price isn’t an overreaction; rather, it’s an appropriate reaction.
The Market Isn’t That Dumb
The broad point here is that when a stock moves in a way that doesn’t purely match the “beat”/”miss” direction implied by analyst consensus, it doesn’t mean that investors are acting foolishly. Nor does it mean that sell-side analysts themselves “got it wrong”.
Rather, like everything else in investing, quarterly earnings are complex. There are no simple rules. An earnings “beat’ doesn’t mean the stock has to rise; a “miss’ doesn’t by definition, imply a plunge (even if that is the most likely outcome).
What matters is the new information that quarterly earnings provide. Quite often, that information simply doesn’t mean much. A good business grows its revenue and profits at a rate roughly in the range that investors expect, and in turn the stock price makes a relatively small move.
But on occasion, that new information is meaningful — in both directions. Disappointing results can mean the business isn’t growing as quickly as investors hoped. Surprisingly strong results, however, can mean the business is performing much better than investors had realized. And in those instances, earnings per share that are only a penny or two better than analysts projected can drive 10% or even 20% increases in the stock price.
A good example here is 3-D printing play Proto Labs PRLB 0.00%↑. The company’s third quarter report doesn’t look that impressive: revenue only rose 7.4% year-over-year. But profit margins increased nicely, with adjusted EPS jumping over 25%. And in a market that is worried the industry is headed for a decline, that report was more than enough to send the stock up over 30% the day after earnings were released.
It bears repeating: the stock market is an argument over future results. It’s precisely because that argument is fought over unknowable answers that investing is so fascinating, so dangerous, and so messy. What quarterly earnings provide is one more data point in that argument. Quite often, that data point largely confirms what investors already believed. But, on occasion, it changes those beliefs. And it’s on precisely those occasions that stocks make huge moves — in both directions.
As of this writing, Vince Martin is short TSLA.
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The majority of U.S. public companies run their business on a calendar-year basis, or something very close; others operate on a fiscal year calendar that aligns with calendar quarters (ie, the fiscal year might end June 30). Either way, those companies need some time to compile audited financial statements. Banks generally report first, about two weeks after the quarter ends; major companies generally need three to four weeks, and smaller companies often a bit longer.
Traditionally, retailers are a month behind, as are a few tech companies. The most notable of those tech names now is Nvidia NVDA 0.00%↑.
Sell-side analysts work for brokeragei firms; buy-side analysts work for institutional investors.
For most companies, analysts will publish their estimates for other metrics as well, such as free cash flow or gross profit margin, but those metrics generally receive little or no attention from financial media sources.
This is obviously a hypothetical, but imagine a quarter in which company executives say the 10 cents per share in ‘extra’ earnings came from a one-time factor which will never, ever, repeat.
Bill.com forecast revenue of $295.5-$298.5 million in revenue; actual revenue was $305 million. Guided adjusted EPS was $0.48-$0.50; actual adjusted EPS was $0.54.
After Q4 2023 results, Bill Holdings guided for revenue of $1.288.5-$1.306.5 million for the full year, and $295.5-$298.5 million for Q1. Subtracting the respective midpoints gets to $999 million for Q2-Q4.
Similarly, adjusted EPS was guided to $1.82-$1.97 for the full year, and $0.48-$0.50 for the first quarter. Subtract $0.49 (the midpoint of Q1 guidance) from $1.895 (the midpoint of full-year guidance) and you get $1.405 for Q2 through Q4.
Great work! Found it interesting. Earnings season can maul people.