Demystifying earnings season

In financial circles the time of year we are currently in is known as 'earnings season' when most listed companies release their full year results for the prior year. The full year report is the most detailed report issued by listed companies and includes audited financial statements that give a detailed picture of the performance and health of the company. So far this week we have already had results from a range of large ASX listed companies, including BHP Billiton (BHP), Domino's Pizza (DMP), ANZ Bank (ANZ) and JB Hi-Fi (JBH).

The companies will generally release the full year report either before the market opens or after it closes to give investors time to read it before trading in the stock resumes. While some reports don't prove to surprise the market at all, others can send the share price soaring or plunging. The casual observer might assume that a good report would lead to a rise in stock price and a poor report would cause a drop in price. This isn't generally the case, however, as the stock reaction is far more dependent on where the report landed relative to expectations. These so called 'expectations' can be exceedingly difficult to gauge and make it very difficult to predict the reaction of a stock price to an earnings report. In addition, markets are generally forward looking and will be more interested in how the company is expected to do in the future rather than how it has performed in the past.  

As an example, BHP reported its full year results yesterday. The headline result was a loss of US$6.4bn as a result of significant expenses related to the Samarco dam disaster and write-downs of its US oil and gas assets. Although there was some good news in the result, the $6.4bn loss was the biggest ever for the company and might therefore be expected to have a negative impact on the share price. The report was release before the market opened yesterday. Despite the poor result, the share price closed 3.3% higher than the previous day's close. The reason for the price increase can be explained using both the 'expectations' and 'forward looking' effects. The costs of the Samarco Dam disaster were well known to the market prior to the release of the annual report and therefore the market was unsurprised by the $2.1bn remediation charge. Furthermore, while the magnitude of the US oil and gas write-downs may not have been known, the drop in oil price over the past year made it clear to investors that these assets would have to be written-down. As a result of this, even though the amount of the loss was very large, its effect had already been priced in to BHP's share price well before the release of the annual report. This 'expectation effect' can be used to explain why the BHP share price didn't react badly to the report, but it still raises the question of why the share price actually climbed after the report.

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The reason for the share price increase yesterday can be explained based on the forward looking nature of the share market. One of the comments made by the BHP CEO was that if commodity prices stay where they are, BHP's free cash flow would be expected to double for the coming year. The market may have been pleasantly surprised by this comment and started to price in some of the expected cash flow increase into the share price. Some stocks already have many years worth of expected growth priced in. Domino's pizza is a great example of a stock where the share price has already factored in significant earnings growth over the coming years. At a share price of $77.00, DMP is currently trading on a price to earnings ratio of approximately 80 times based on 2016 earnings. In simple language, this effectively means that if you bought Domino's pizza at the market price, it would take 80 years to pay off your investment using the 2016 earnings of the company. The current stock price, therefore, implicitly assumes very strong earnings growth in coming years. Whether or not DMP is a good buy at current prices does not depend on whether you think their earnings will grow next year, but rather it depends on whether you think their earnings will grow more than the market expects them to grow. Understanding that the share market reacts to expectations and not absolute performance is critical to investing successfully.

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This article was written by William O'Loughlin – Local Investment Analyst, Rivkin Securities Pty Ltd. Enquiries can be made via william.oloughlin@rivkin.com.au or by phoning +612 8302 3600.