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Why a stock goes up after earnings - and how to trade it

We lay out the four most important metrics you need to understand about a stock earnings report and then a technique for trading the stock once you know them.

 

Earnings season provides an excellent opportunity to day trade stocks because the earnings report provides a known catalyst at a specific time for the price to move up or down. However, trading stocks during earnings season is a high risk: reward business because the reports can cause significant moves in the price – UP and DOWN!

 

Definition: An earnings report is a legally required update from a company about their performance over a period of time. In the United States earnings are released every three months – that’s quarterly. In Europe companies tend to report earnings semi-annually. The companies tend to release the earnings reports either after the close or before the bell – i.e. outside of regular trading hours.

 

Why watch earnings?

Needless to say if the numbers are good, the stock tends to rise once the market opens, while if the numbers are bad, the stock tends to fall. Investors will measure the numbers – including the 4 below – against analyst expectations. Analysts will listen to the company’s own prediction for the next quarter and do their own financial analysis to make a forecast. Whether the actual results beat or miss those estimates tend to determine whether the stock moves up or down.

So without further ado –

 

The top 4 metrics

  1. Revenue

This is a fancy word for the value of the all the sales that the company made. This is just the incoming money- and does not include the outgoings – like costs of paying suppliers and workers etc. It goes without saying that a company needs to make sales and have money coming in to be successful.

 

For example if Tesla sold one Model S car for $75,000 in three months- it’s revenue would be $75,000. Of course that would be a terrible quarter for Tesla! Let’s look at the real revenue number for Tesla in Q2 of 2020. Tesla’s estimated revenue was $4.67 billion but the company actually reported $6.04 billion – a 29% upwards surprise.

NOTE: Where do you find the expected and actual statistics? There are many websites including Yahoo Finance and MarketWatch – the above picture is from Earningswhispers.com

 

  1. EPS (Earnings per share)

Earnings are the profits the company makes – that’s revenues minus costs. Tesla may sell the Model S for $50,000 but it may cost $20,000 to build it – meaning the earnings are $30,000. Then we go one step further by evaluating the earnings per share.

If Tesla had issued 1000 shares – the earnings would be $30,000 divided by 1000 – which equals an earnings per share (EPS) or $30. Reverting back to Tesla’s real earnings, we can see the company reported an EPS of $2.14 when expectations were for a loss of ($0.71).

 

  1. Product sales / User growth

Many companies will have a core product – in the case of Tesla it is its cars – in the case of Apple it is the iphone – but in the case of Facebook – it is how many new users its platform is getting. Since these products and services are the core of the business – it gives investors a good understanding of what growth prospects are for the company.

 

Tesla vehicle deliveries guidance

 

In Q2 2020, Tesla delivered 90,650 vehicles, about 2,250 units more than in the first quarter of 2020. However, this is a decline year-on-year. The second quarter in 2019 had seen 95,200 deliveries worldwide.

 

  1. Earnings Guidance

Most companies will guide investors to what they expect to happen in the following quarter. If a company guides that its revenues and EPS will be higher than the current quarter, investors buying the stock for growth will be happy but guidance lower than in the current quarter would be disappointing. If ever a stock drops following a strong earnings report that showed better EPS, revenues and product sales than expected, it is often because of the company has guided that the following quarter will not be as good.

 

As an example, Tesla will typically offer guidance on full-year vehicle sales. The company expected to deliver 500,000 vehicles in 2020 but did not update the guidance in Q2 because of uncertainty around the COVID-19 pandemic.

 

How to buy the stock after earnings

Here are 3 things to do once earnings are reported

  1. Check that all 4 metrics beat expectations
  2. Did the price move higher afterhours?
  3. Buy the momentum after the initial jump.

 

First = we want to establish that the earnings report was ‘good’ by ticking off that all the metrics beat consensus expectations.

Second = there are computer algorithms and market makers controlling prices out of exchange hours. If these professionals push the price up – you have your confirmation that the ‘good’ results were well-received.

 

breakout after earnings

(Source: WarriorTrading.com)

 

Once the stock opens for trading after good results with a move higher in the price afterhours, then price will typically ‘gap’ up. This means it is not possible to trade at yesterday’s closing price, you must wait for the next available market price today- which is higher by the amount of the gap. High-frequency traders will then possibly push the price up even higher following the gap- before you as a trader have a chance to trade. BUT all is not lost- just because you missed the initial move. Let’s not forget what the earnings report signals – it signals the company is doing better than expected and the share price should move higher until some new information becomes available later that says it should not.

 

Third = use the confirmation of the earnings release being better than thought as a fundamental backup to increase the probability that the short term momentum will continue. Different order types can be used to buy the stock– but the goal is to buy as soon as possible after the open- one option is to buy on the open of the 2nd 1-minute candlestick.

 

Exiting the trade is a personal preference- typically traders will use time as a guideline, selling the stock at the end of the day or two weeks later for a profit or cutting losses if the price falls back below the initial entry point.

#Stocks #Advanced trader #Technical Analysis

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