Earnings Vs. Revenue: What to Look for This Earnings Season

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Oct 20, 2015 1:02:40 PM

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earningsI have talked about valuations quite a bit recently, and, as I have noted, they are certainly important. Valuations, however, are largely subjective and change over time; there is little you can do to manage or react to them.

Earnings, however, are objective—the numbers are what they are, come out every quarter, and reflect actual business activity. As such, we need to watch them even more closely.

Should we worry about an “earnings recession”?

The current assumption among analysts is that we will have an “earnings recession”; that is, two consecutive quarters of earnings declines. This would be the first since 2009, and, presumably, it would be bad for the market, right?

Not so fast. Any consensus view (like the current earnings recession view) is, by definition, already priced into the market, so we have to look for new information—information that the market does not expect—to see what prices might do in the future.

To that end, it is useful to track sales and earnings as they actually come in and compare them to expectations. It is also useful to analyze highly visible headline companies—Walmart, for example, or IBM—to see how they differ from expectations.

Let’s look at the big picture first. As of last Friday (and, remember, it’s pretty early), with 58 companies, or 12 percent, of the S&P 500 reporting, earnings growth is actually above expectations for 81 percent of them, which is higher than average. The average beat is 6.6 percent, which is also significant. Although earnings are still expected to decline in aggregate, the expected decline has dropped from 5.6 percent to a current 4.6 percent. This kind of generally better-than-expected results has historically been good for the market.

Looking at the surface of this news, it would seem that, for this quarter in aggregate, earnings are likely to beat expectations. This is actually pretty normal, as companies try to guide expectations to a level they are pretty sure they can beat. Nonetheless, when earnings come in higher than expectations, the market often gets a boost. The results, even with a decline, can therefore be a positive for the market over the rest of the year.

Revenues: The not so good news

For revenues, though, the news is not so good. Only half of companies reporting so far beat revenue estimates, which is below average, and the average beat, at 0.5 percent, is also below average. In addition, this would be the third consecutive quarter of revenue decline, if expectations of a 3.2-percent drop pan out. This means that we are already in a revenue recession, although no one seems to be using the term.

Investors are usually more focused on earnings than revenues, but that is not always the case. Right now, the revenue figures are more worrying, albeit over a longer time period. Companies can continue to grow earnings faster than revenues for some time, but when revenues actually decline, that becomes harder. Slowing revenue growth, especially over several quarters, means continued slower earnings growth, which will be a headwind for the future. The question is when investors will start to worry about this.

You can see how these points played out in two specific cases. For example, IBM did well on earnings, but had a terrible revenue report—and the stock has been punished. That lower revenue and lower future guidance represented new information (as I alluded to above), and it trumped the good earnings, which were already priced in. Lower revenues will certainly mean slower earnings growth at some point, and the market has now priced that in as well.

Much the same thing happened with Walmart, with the impact of higher labor and technology costs coming in as new information—and reducing both expected future earnings growth and the stock price.

In the short term, companies should continue to beat earnings expectations, and that should be positive for the market. In the longer term, the divergence between revenue growth and earnings growth suggests future appreciation will be more difficult, and with lower growth, the current valuation levels will look even more expensive. In the short term, the market looks good, but the risks look more serious in the longer term.

All figures are per FactSet.

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Tune into Yahoo Finance's The Final Round on Thursday, March 12, between 2:50 and 4:00 P.M. ET to hear Brad talk about the market. Exact interview time will be updated once confirmed. Watch at finance.yahoo.com

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