What Is Earnings Per Share?

The money that a profitable company makes is referred to as its earnings. A commonly used metric for comparing earnings – and the one the market focuses on – is earnings per share, which is the company’s total earnings divided by the number of shares outstanding. Many companies are followed by securities analysts, each of whom devises an estimate of likely earnings for the quarter. The average of these estimates is known as the consensus estimate; this is the number the market expects the company to meet.

As noted earlier in this chapter, public companies must file their quarterly reports for the first three quarters within 45 days of quarter end. If the quarter ends on March 31, the report is due on or before the following May 15. The annual report is due within 90 days after the year end, so if the year end is December 31, the report is due approximately at the end of March the next year. Those reports must set forth, at the very least, earnings before and after taxes. While we never know when an earnings report is coming – until the company itself tells us – we do know approximately when it is due if we know what its quarter ends are.

However, companies usually issue a separate earnings report in the form of a press release that elaborates upon operating results. Companies often announce in advance when earnings will be released, though this date can be revised. Calls and puts can get quite expensive; that is, implied volatility of the options can increase in the days or weeks before the earnings release (the pre-announcement period). This happens because of increased demand for options by both hedgers and speculators, because the rising demand drives option prices higher.

The canny call writer can exploit this high premium, provided due care is used. Before diving into the earnings conundrum, company guidance must be understood.

Pre-announcements

An earnings pre-announcement is the company’s public statement about an upcoming earnings announcement made before the official earnings release and intended to guide the market’s expectations, and they are becoming more common. Managers use them as “mid-course corrections” to provide analysts and the investing public a heads-up in order to lessen the impact on stock price – known as “managing” the market’s earnings expectations. An example would be to subtly cause analysts to lower their estimates, so that the actual earnings look better or even provide a “surprise” (higher than expected).

Managers also use preannouncements when the earnings number they will ultimately report is far from analysts’ earnings forecasts (unless of course, the analysts are low), when there is a large variation in analysts’ forecasts, or when managers have bad news. Companies are not required by law to respond to statements, analyses or estimates made by persons outside the company, but when analyst estimates are bad and the company does not guide, what inference can we draw but a negative one? However, a positive preannouncement may provide some comfort against an earnings surprise.

Companies now do such a good job of managing earnings, and of making sure that analysts have reasonable earnings expectations, that you just don’t see huge earnings surprises much any more. Large surprises can produce lawsuits and regulatory investigations. I noticed in 2005 that stocks more frequently tend to sell off before the announcement – that is, the market buys on rumor and sells before the earnings report. This happens on an assumption that most buyers already are in and sellers are getting out before the anticipated sell-off.

One Harvard Business School study found that companies release earnings news through both preannouncements and actual announcements, but that from the perspectives of both analysts and investors, more information is conveyed in preannouncements. Analysts and investors also seem to regard bad-news preannouncements as more informative than good-news preannouncements, which is consistent with the fact that bad-news preannouncements tend to be farther away from expectations.

In other words, analysts’ earnings estimates are getting less and less weight from traders and investors, which are instead relying more on the company’s preannouncement numbers. Another study found that company preannouncement numbers are more accurate than analysts’ earnings estimates prepared using the company’s actual preannouncement numbers. Well the company knows; analysts are guessing. When earnings come in lower than the company guided, the stock price can take quite a spanking. 

Forward Guidance

But – the problem isn’t just current earnings. Often the company will, in tandem with the earnings report, release forward-looking earnings estimates (“guidance” releases) for the next quarter or longer future period. Guidance releases can have a huge bearing on the company’s long-term financial prospects. If the guidance or any trends discerned by the market indicate negative future results, the stock price will be immediately affected, even if the recent quarter’s earnings were stellar. In fact, companies trading at high P/E ratios can collapse.

To Write Earnings, or Not to Write?

If the earnings report is below the street’s expectations (the consensus number), a sell-off is likely. A stock that has advanced on preannouncement expectation may run up even further if the news is better than expected, but one can’t count on it! Stocks frequently run up on earnings anticipation and then sell off even when they do make their earnings numbers, because everyone who wanted the stock has already bought (buy on rumor, sell on news).

That is, when the stock has run up preannouncement, the finest performance oft-times has already been priced into the stock, so there’s nowhere for it to go in the short term but down, as the speculators exit. The hard fact is – you just can’t be sure.

Many companies have a calendar (December 31) year end, but many do not. For those with year ends that fall on the end of a calendar quarter, the earnings “season” tends to be very roughly from the 10^th through the 30^th of the month following the quarter or year end: e.g., January 10-31 for the quarter ended December 31. Alcoa, a bellwether stock if there ever was one, tends to kick off earnings season.

Since stocks report four times a year, and since there is a preannouncement period each quarter, they each can be subject to “earnings anticipation” for a total of several months during the year. About the only exception is the “defensive” dividend-paying company that trades below book value and is so boring that only a surprise of unlikely magnitude will move it.

During earnings season, there are only a few choices to be made by the buy-writer: 1) warm the bench, meaning simply to not write, 2) write only companies that already have reported, which is by no means a bad strategy, 3) write companies in the current expiration month where earnings will be reported in the next expiration month (ex: write January calls if earnings are coming out after January expiration), or 4) write a company across the report date, which clearly is the riskiest alternative.

Sitting out earnings season is a strategy employed by many covered writers. There is nothing wrong with it, but being sidelined that much of the year is not for everyone’s taste; nor is it necessary. Since many companies report early in the season, it is always possible to find good covered call candidates that have already released earnings. Call premium may be lower once the company already has reported than for those still to report, but it should be lower: the suspense is over.

When the earnings report is due in the next expiration month, it usually is the case that it is relatively “safe” to write the current expiration month, at least from an earnings standpoint. However, in this strategy, we want to see earnings reported at least three or four days into the next expiration month. For example, if expiration (always a Saturday) is January 18^th, we would want to see earnings no earlier than the 23^rd or 24^th. This leaves a bit of breathing room in the event the stock does pull back in the days before the announcement.

A company planning to announce before expiration can be a great trade, and that often is the case when writing is confined to the best and most consistently profitable companies. However, this is never certain, and even great earnings will be swamped by negative guidance for coming periods.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.