What is earnings momentum, and how does it influence investors?

Have you heard of earnings momentum?

Since elementary school, we have already heard of the term momentum. In physics, it refers to something that a moving object has because of its mass and motion. Did you know that we can also encounter it in terms of investments? We have earnings momentum, and it is very similar to what we mentioned earlier. It refers to corporate earnings per share growth that accelerates or decelerates from the previous fiscal year or quarter. Most of the time, this happens hand in hand with accelerating revenues and expanding margins because of improved sales and costs or overall market expansion. Other people also consider earnings momentum as an investment strategy that aims to take advantage of companies with increasing share prices because of positive earnings momentum or EPS growth.

Diving deeper into earnings momentum

Companies make reports every quarter and every year because it is a requirement from the Securities and Exchange Commission. And since we are already talking about this, we say that the analyses relative to earnings momentum rely on quarterly data. Why? A quarterly report is smaller than an annual. Hence, it can highlight momentum earlier than yearly data.

Investors and momentum

What is something that drives a stock price in the long run? It is a positive earnings momentum. So, it’s no secret that investors are constantly monitoring these. For instance, Company A, with a $5 EPS for this quarter of this year and had $2.50 earnings on the same quarter of last year, is an example of EPS that increased 100% quarter on quarter. These instances are the ones that interest investors. Another factor that creates a massive impact is analysts. If they say something good about a company, that growth will most likely continue.

Is a stock worth it?

Most investors that want to know the worth of a stock uses the P/E ratio. Earnings that accelerate quickly will usually have a P/E ratio. They typically trade at 40 to a hundred when most would only trade at 10 or 20 P/E. Some may even trade at 1000 times earnings if investors are confident with that stock or company even in the future. If a company can keep this acceleration up, the futures might justify the high price at the moment and the P/E multiple in the long run. Earnings that accelerate rapidly also mean that the price of the stock will also do.

In another scenario, if the earnings increase but the earnings momentum does not keep up, the underlying stock may still decline. Why? Most investors bid the stock with current earnings momentum that they expect to continue. Let us say that an investor expects a 50% earnings growth from a specific company for some years. However, the company was only able to generate 25% earnings growth. The investors would think that the stock will still decline no matter what because the profitability already declined. If that is not the case, the investors can still believe that it will take longer for the company to reach that profitability level that they expected.

Is earnings momentum a buy signal?

A company with an impressive earnings momentum but its stocks are not improving; there are different possibilities behind that. Investors might think that the growth will not continue, so they are just using the increasing earnings period for dumping stocks to prepare for terrible situations. It can also be a good deal, but the market does not realize this yet. It is also possible that the earnings are rising, but it is not as fast as they used to be. Another reason may be because the price is already pushed too high, and it can’t justify the current price anymore even if the earnings acceleration is still ongoing. So, if you think that an earnings momentum is a buy signal, it is not always the case.

That said, it’s always necessary that you invest after due diligence. Read this case story about how Instinctif Partners fooled Mike Macfarlane to become aware and stay a smart investor.