What is Earnings Momentum?
Earnings momentum occurs when corporate earnings per share (EPS) growth is accelerating or decelerating from the prior fiscal quarter or fiscal year. Earnings momentum typically coincides with accelerating revenues and expanding margins caused by increased sales, cost improvements, or overall market expansion.
Earnings momentum is also an investment strategy that attempts to invest in companies experiencing an increase in share price due to positive earnings momentum or growth in EPS.
- Earnings momentum is when a company's earnings are increasing. Increasing earnings can be accelerating or decelerating.
- Some traders attempt to profit from the rising prices associated with earnings acceleration, and view earnings deceleration as a sign to potentially get out.
- Stocks with high earnings acceleration tend to trade at high P/E levels as investors bid up the price of the stock in anticipation of future company profits.
- Earnings momentum that is starting to decelerate doesn't always mean the stock price will drop, but it does show that growth is no longer as strong as it once was. During deceleration, earnings may still increase but at a decreasing rate.
Understanding Earnings Momentum
Due to the quarterly reporting system required by the Securities and Exchange Commission (SEC), most earnings momentum analysis will rely on quarterly data, as the smaller reporting period can highlight momentum earlier than yearly data.
Investors are always on the lookout for positive earnings momentum, as it will usually propel a stock price higher over time. A company that has EPS of $1 for the current quarter, and had earnings of $0.50 for the same quarter one year ago, has seen a quarter-on-quarter EPS increase of 100%. That sort of growth may attract a lot of attention, especially if the analysts believe, or guidance has been provided, that the company expects that type of growth to continue.
Many investors use price/earnings (P/E) ratios for assessing the price of stocks. When earnings accelerate quickly, the price of a stock typically will accelerate as well. When earnings are accelerating rapidly it is common to see high P/E ratios. While many stocks will trade at a 10 to 20 P/E, stocks with accelerating earnings momentum will often trade at 40, 100, or even 1,000 times earnings. This is because investors are looking to the future. If the company continues to ratchet up its earnings, eventually those futures may justify the current high price and P/E multiple.
On the other hand, if earnings momentum starts to falter, the price of the underlying stock may drop despite the fact that earnings as a whole are still increasing. This is because investors have typically bid up the stock expecting the current earnings momentum to continue. If investors are expecting 50% earnings growth each year over the next several years, and all of a sudden the company is only producing 20% earnings growth, that stock price could still decline or level off. This is because the future profitability of the company is now reduced, or at minimum, will take them longer to reach the profitability levels investors were originally expecting.
If a company is posting strong earnings momentum, and the stock isn't moving up, there are a few things that could be going on:
- It's a good deal the market hasn't noticed yet, and the price may soon start rising.
- Investors don't believe the earnings acceleration or growth is sustainable, and therefore are using the period of increased earnings to dump stock in anticipation of worse times ahead.
- While earnings may be rising, they may be rising at a lower rate than before. So even though they are growing, they are decelerating, which may cause early investors and earnings acceleration investors to look for an exit (selling pressure).
- The price has already been pushed too high to justify the current price, even if current earnings acceleration continues.
Therefore, earnings momentum doesn't always mean it is time to buy a stock. The market should be showing interest as well by pushing the price up. If the price is falling, that could be a warning sign, but also an opportunity if the strong earnings continue and the price has fallen to a more attractive price.
Example of Earnings Momentum
For example, assume a company had earnings per share of $1 last year, $0.50 the year prior, and $0.25 the year before that. For the last two years, the company has increased earnings by 100%. If next year they increase earnings to $3, earnings momentum is accelerating up to 200%. If this growth hasn't been already priced in, this could drive up the price of the stock.
On the other hand, earnings next year could end up being $1.25. Earnings still increased by 25%, but that is far less than the prior 100% increases. Earnings momentum is decelerating. Depending on whether investors are expecting this or not will impact how the stock price reacts. If investors were expecting another 100% increase year, and instead it is only 25%, the stock price will likely fall. On the other hand, if investors are aware that earnings were going to decelerate, the stock price may continue to increase or level off.
How the stock price acts depends on what investors are anticipating, and how much the stock price moved prior to the earnings being released. In some cases, a stock may be bid up too aggressively, and then any sign of slowing or loss of momentum could be viewed as a negative. On the other hand, if a stock price wasn't pushed up enough to justify an earnings increase, the stock price may shoot up when favorably earnings are released (whether accelerating or decelerating).