Reacting To Earnings Surprises

Reacting To Earnings Surprises

This month, most companies will announce their earnings results. While some companies announced earnings results last month, one pattern that I observed is how investors reacted to the earnings results. For some firms like Netflix, the stock price increased, while for Meta, the stock price nose-dived. These results will have more interest than expected earnings results because of the economy and the looming risk of recession. Thus, the results will provide a pattern of consumer spending and the impact of inflation on consumer spending. In this post, I provide my insights on how investors react to earnings surprises and why focusing on simple metrics like EPS and P/E multiples do not provide an accurate picture of the firm’s valuation. Moreover, applying the same metrics to Zomato, TCS, or Tata Steel is incorrect, and metrics must change according to the firm’s lifecycle.

Why Analysts Use Price Metrics

Most analysts use price metrics because of their simplicity. However, I have observed investors losing their cool when companies report lower earnings per share that diverge from their expectations, even if the divergence is not more than a few cents. Such impulsive reactions from investors make me wonder why markets focus so much attention on a single metric and so little on the rest of the news in the earnings report. In my view, some of the reasons for impulsiveness is because of:

1. Analysts find it convenient to use a simple metric like EPS and track it against developing a narrative for the company and then valuing it on the narrative.
2. As there are more stock market traders than investors, we must understand traders focus on the short term and give importance to price shifts than value shifts. Thus, traders identify metrics that other traders use to price a firm and will continue to use the metric despite knowing that firms can manipulate the metric or that metric does not reflect the firm’s intrinsic value. For instance, firms manipulate accounting earnings by using different depreciation techniques, adding restructuring charges where the revenue recognition does not match the expenses or improving reported earnings by reducing intangible investments like R&D, which is shown as expenses by the accountants.

Thus any stock price changes during the earnings results are a pricing game which may or may not change the intrinsic value. Analysts have expectations on a metric like EPS/revenue growth/growth in subscribers, and companies try to deliver on that metric or beat the market expectations.

Pricing Metrics and Corporate Life Cycle

The most common metric analysts use to evaluate a firm is earnings per share (EPS). However, other metrics include growth in subscribers (Netflix), growth in phones sold (Apple), and growth in customers (Infosys). As metrics change depending on the firm, how do investors select the right metric?

I use the following framework:

• For young startups like Zomato, investors must focus on cash reserves and access to capital. In the funding winter, where access to capital becomes challenging, cash reserves determine the firm’s growth and survival.
• Earnings per share become a valuable metric for firms with a defined business model and not exposed to structural shifts due to disruption of new technology risk. Here, the market size is stable, and market shares are sticky.
• For evolving firms like Palantir/Snowflake, investors focus more on revenue growth than earnings. For instance, social media companies focus on the user’s growth and the potential to monetize the users.

In the following table, I provide the pricing metrics and multiples that investors must focus on depending on the firm’s lifecycle.

Thus, startups during the pre-revenue stage must focus on TAM, while as companies mature, the focus must change to cash flows and earnings. Thus, we see VC focusing on TAM when evaluating startups, and as companies grow, investors must focus on subscriber growth (Netflix) and how well they can monetize. Likewise, with IT services companies like Accenture, revenue growth is crucial, but earnings determine the stock price.

Risks In Using Pricing Metrics

Though I have provided metrics to focus on when evaluating firms, there is a risk of solely relying on these metrics and arriving at a judgement. Some of the risks include the following:

1. The determinants of a firm’s value are its capacity to generate underlying cash flows from existing assets, the expected cash flow growth rate, the firm’s efficiency in delivering the growth and the risks in the potential cash flows. Unfortunately, no single metric can capture the firm’s determinants. Moreover, when we focus on a single metric that focuses on one of the firm’s determinants, we assume that the other determinants do not change, which is a flaw. For instance, when firms improve their earnings per share, there is a higher chance that the firm has entered a growth market that has higher risk. Thus any increase in cash flows can be offset by the increase in risk. Thus, an increase in earnings can increase or decrease the firm’s value.
2. When focusing on a single metric, you develop a tunnel vision and ignore the rest of the firm’s narrative. So, for instance, when subscribers’ growth determines the Netflix stock price, analysts focus on subscriber additions that focus on the rest of the narrative, like growth in earnings.
3. Further, when firms realize that investors focus on a few metrics, they manipulate the earnings results to focus on that metric. For instance, when analysts focus on EPS, firms can play accounting games to make their EPS better than it looks.
4. Analysts will change the metrics when there is a transition in the firm’s life cycle or macroeconomic conditions. For instance, a couple of years back, analysts focus on user growth despite the firm losing cash flow. However, with the risk of a recession looming around, analysts focus more on earnings than growth. Thus, firms that play by the market rules must adapt as the situations change, or they will see stock prices declining, as in the case of Meta platforms.

Final Thoughts

Traders play the pricing game, and good traders understand the metric that influences the stock price and can estimate better than others how the firm will perform on that metric. However, for long-term investors that focus on value, understanding the firm’s business model, its narrative and how its strategic assets perform becomes more crucial than making buy/sell decisions relying on one metric.