The art of earnings reports

By Felix Salmon
August 13, 2012
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Arthur Brisbane, the NYT public editor, has a characteristically skittish column on earnings reports. He quotes lots of journalists (Dean Starkman! Gretchen Morgenson! Larry Ingrassia! Jim Cramer!), and ends with advice worthy of Polonius:

Always be sure to meet company spin with appropriate skepticism. If nontraditional profit metrics are involved, bring the reporting back around to good old-fashioned net income. If a company wants to strip out adverse factors, be sure to strip them back in.

And don’t get swept away by the Kabuki theater of gerrymandered expectations.

This is what you get when long-in-the-tooth journalists with no business-desk experience try to parachute in and tell financial types how to do their job: “On the assumption that a lot of Times readers are also investors,” writes Brisbane, “I wondered how earnings articles could be tailored to help readers with investment decisions.”

Let’s dispatch that one quickly: there are things which help investors with their investment decisions. And there are NYT articles about corporate earnings. And there is no reason at all for the latter to attempt to be the former.

Brisbane does, dimly, understand that earnings reports are problematic, from a journalistic perspective. But he doesn’t understand the fundamental tension that explains why they’re so difficult, which is that the news value of earnings reports is entirely orthogonal to the value that the market finds in them.

As far as the market is concerned, earnings reports are all about short-term tactical positioning. Everybody’s trying to position themselves against what they think the earnings report will say, and how they think the market will react. At its simplest this is just a question of whether the company will “beat expectations” or not, but there are second-order and third-order effects as well, and much of the smart money is doing all manner of highly-complex trading in the options market rather than the cash market. As a result, the reaction of the share price to the earnings statement, unless it’s huge, generally tells you almost nothing about the substance of that statement.

The sensible reaction to such a world, if you’re a journalist, is Larry Ingrassia’s: to ignore nearly all earnings reports, unless there’s real news value in them or unless there’s broad public fascination with the company and its fortunes. And when you do cover a company’s earnings, the sensible thing to do is to try to use them as a window onto a broader story, rather than as a significant news event in and of themselves.

Doing so naturally opens yourself up to the kind of gotchas that Brisbane opens his column with. He seems to be shocked that different news organizations might have different takes on the same earnings report, and concludes that such stories are nothing more than “a Rorschach test for reporters: what they see is what they think they see”. That’s incredibly unfair: the reality is that precisely because the news value of most earnings reports is so slim, smart news outlets treat them as a way to provide a broader perspective on the company. And there are as many ways of doing that as there are reporters.

On the other hand, the financial press doesn’t have that luxury — if you’re working for a financial newswire, or for the Wall Street Journal, then you have to be focused on the stock at least as much as you are on the company. As a result, you have no choice but to talk about market expectations. What’s more, you have to go into some detail about the actual earnings, and you have to write about whatever metrics the market is paying most attention to. Sometimes, that will be “good old-fashioned net income”. Often, it won’t be.

If you own stock in a fast-growing company in a young market, for instance, you would probably be rather worried if that company started posting outsize profits, rather than reinvesting them in growth. And right now, when companies are sitting on enormous cash piles and the last thing they need is even bigger cash piles, a large net profit is in many ways a sign that the company in question has reached the limit of what it can do, and has no real ability to reinvest capital or to boost future growth.

Dell, for instance, had net income of $635 million in the last quarter, and $3.2 billion over the past 12 months; that’s good for a market capitalization of just over $20 billion. Amazon, by contrast, had net income of $7 million in the last quarter, and $377 million over the past 12 months: a tiny fraction of the kind of profit that Dell is making. And yet it has a market cap of more than $100 billion.

So let’s not pretend that the One True Earnings Report is the one that concentrates on net income as the most important indicator every quarter. Especially when you have things like large one-off write-downs, net income becomes downright misleading unless its components are properly explained. And let’s not pretend, too, that there’s some unique truth underlying every earnings report, and that if journalists were only perspicacious enough, they’d all write exactly the same thing. Your audience matters: are you writing for traders, or are you writing for general-news consumers? And if it’s the latter, then in many ways the faster you get away from the earnings and move onto something more interesting, the better.

As for general readers, there’s really no point in reading the typical earnings report in a financial publication. If you’re a trader, and you don’t already know what happened with the earnings, then, well, you shouldn’t be a trader. And if you’re not a trader, these reports are not for you. If, on the other hand, you find yourself reading about an interesting company’s earnings, somewhere, and the story grabs your attention, then there might well be something worth reading there. But if there is, then the chances are that the worthwhile information is informed mostly by reporting that preceded the release of the earnings. They’re just a news hook, really.

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Comments
6 comments so far

This is absolute crazy town:
“a large net profit is in many ways a sign that the company in question has reached the limit of what it can do, and has no real ability to reinvest capital or to boost future growth.”

What does profitability have to do with reinvestment opportunities? It sounds more like you’re talking about cash levels and shareholder distributions, which are fairly unrelated to profitability in terms of reflecting available opportunities. Are you asserting that the most profitable companies in the world are the ones with the *least* future growth available to them?

Seriously, there are all kind of random statements here that I don’t think have any basis in fact. What does it mean to be all about “short-term tactical positioning”?

And how do you propose that “much of the smart money is doing all manner of highly-complex trading in the options market rather than the cash market”, without those option price movements spilling over into the equity markets?

There’s a fairly rich body of research in finance/accounting/economics looking at market response to earnings announcements and, not surprisingly, the market response tends to be highly correlated with the earnings surprise. Not because of some short-term tactical positioning story, but because investors are bayesian and update their beliefs about future cash flows based when they get new information.

This post is just filled with unsupported assertions that are either nonsensical or don’t ring true.

Posted by Beer_numbers | Report as abusive

A lot of odd stuff going on here. This seems goofy:
“a large net profit is in many ways a sign that the company in question has reached the limit of what it can do, and has no real ability to reinvest capital or to boost future growth.”

What does profitability have to do with reinvestment opportunities? It sounds more like you’re talking about cash levels and shareholder distributions, which are fairly unrelated to profitability in terms of reflecting available opportunities. Are you asserting that the most profitable companies in the world are the ones with the *least* future growth available to them?

Seriously, there are all kind of random statements here that I don’t think have any basis in fact. What does it mean to be all about “short-term tactical positioning”?

And how do you propose that “much of the smart money is doing all manner of highly-complex trading in the options market rather than the cash market”, without those option price movements spilling over into the equity markets?

There’s a fairly rich body of research in finance/accounting/economics looking at market response to earnings announcements and, not surprisingly, the market response tends to be highly correlated with the earnings surprise. Not because of some short-term tactical positioning story, but because investors are bayesian and update their beliefs about future cash flows based when they get new information.

This post is just filled with unsupported assertions that are either nonsensical or don’t ring true.

Posted by Beer_numbers | Report as abusive

Not sure what you are trying to say, Felix, and the comparison of Dell and Amazon leaves me scratching my head. (For the record, I wouldn’t consider investing in either one at this time.)

I do agree that net income is less useful than the outlook, and even less useful than the details on business dynamics.

As for the popular consumption articles, I’m most interesting in reading that “XYZ has fallen 20% on weak revenues”. Sometimes (as with Nike a month ago), that is an overreaction.

Posted by TFF | Report as abusive

“Orthogonal” is like the secret handshake of posers worldwide. And kicking an old man in the shins and calling him gramps is really lame. Sammon needs another wedgie.

Posted by billyjoerob | Report as abusive

Felix – perhaps the real truth is that understanding what really matters in an earnings report is hard and can’t be done by newswire journalists who are only capable of reading one number (net income).

I used to think you had a pretty deep understanding of the markets but this entire post makes me wonder.
For example, “the reaction of the share price to the earnings statement, unless it’s huge, generally tells you almost nothing about the substance of that statement”.

This could not be more wrong.

You just don’t know what the substance is.
Just because you are ignorant, it doesn’t mean that smart money is.

Of the hundreds of calls I have covered (on companies I know) I can’t explain the stock move in perhaps 5% of them.
And those tend to be the real money makers!

Posted by TinyTim1 | Report as abusive

I used to work on the earnings reports of companies like 3M. They are mostly a joke and tortured beyond much correlation with the truth. Multi-page sections which could be summarized by the sentence “if we sell less stuff next year we will make less money, and likely we will sell less stuff”. A desperate desire to obscure obscure obscure.

Just invest in some index funds and leave the earnings report to the full-time professionals and the suckers (the overlap of which is quite extensive).

Posted by QCIC | Report as abusive
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