Updated 4/18/22
As we leave a tumultuous first quarter behind us and enter earnings season, it is time to review where and how the stock market and economy intersect. While it can seem crazy to see the stock market demonstrate strength since 2020 given the current economic environment of rampant inflation and mixed economic data, understanding what the stock market actually follows helps to explain this disconnect.
In the same way home values are determined by the income you could generate by renting, the valuation of the stock market is driven by corporate earnings. Every three months, companies must publicly disclose their corporate earnings for the quarter so that investors can remain informed on the health and success of the company. Conveniently, the majority of companies report this financial information around the same time frame; this is known as “earnings season.”
During earnings season, there are two main financial measures that investors focus on: revenue growth (also known as sales growth), and earnings (net income) that are measured as earnings-per-share, or EPS. Generally speaking, earnings tend to be the most important measure, as it is a measure of the true profitability of a company. For example, a company can have positive sales growth and negative earnings if the company’s expenses are high enough. By observing earnings, investors are able to view how efficient a company is with its reve
While negative earnings are typically a bad thing, there are exceptions. For example, companies that are in their growth stage tend to reinvest most of their revenue back into the company to promote growth, innovation, increased market presence, etc. By reinvesting this money into the company, these growth companies may have both astronomical sales growth and negative earnings. In this situation, negative earnings would not be as strong of a deterrent as it typically is, as investors would understand that the company is currently more focused on maximizing its growth than its profitability. In short, both sales growth and earnings are invaluable for understanding a company’s financial health in their own, unique ways.
Now that we know which financial measures are important, you may be wondering why earnings season tends to see such violent and volatile swings in stock prices in either direction. In between earnings seasons, Wall Street analysts track companies and create estimates for their upcoming earnings releases, which is where the idea that a company “beats” or “misses” on earnings and revenue comes from. If a company significantly misses these estimates, this is typically when you will see steep, one-day drawdowns. Likewise, companies who blow out Wall Street estimates are typically the situations where you will see a stock’s price skyrocket overnight.
