When looking at the stock market, one of the key things we should focus on are earnings, as they represent the bedrock of a stock’s value. The best way to value stocks—the dividend growth model—analyzes earnings, growth rates, and required returns to determine what a stock is worth fundamentally. Growth rates and required returns are subjective estimates, but earnings are facts. Everything starts from there.
So, when we talk about the market, what we should be—but often are not—talking about is earnings: what they are, where they are going, and why they are going there. Now that companies have started reporting their earnings for the second quarter, we can do just that.
On track to beat expectations for Q2
According to FactSet, as of July 7, 5 percent of companies in the S&P 500 Index had reported earnings, so it’s early days, but we can still pull out some useful information.
Of those companies, 78 percent reported beating their earnings estimates, and 87 percent reported beating their sales estimates. These numbers are well above the average of the past five years, where 68 percent of companies beat on earnings and 53 percent beat on sales. More, companies are beating estimates by about 8.2 percent, which also betters the five-year average of 4.2 percent.
To put this into context, on average, in the past five years, with 68 percent of companies beating estimates by about 4.2 percent, actual earnings growth has come in 2.9 percent above what was expected at the end of the quarter. Earnings growth expectations at the end of the second quarter of 2017 stood at 6.6 percent. If the above holds, it would bring earnings growth up to 9.5 percent, close to double digits and a material improvement from what is expected. If things go really well, and the remaining 95 percent of companies fare as well as the first 5 percent, we could see earnings growth close to 13 percent—nearly twice what is expected.
Although I don’t believe that will happen, I do think it quite likely that earnings will come in much better than expected, based on the data so far. Further, this would suggest that, even if valuations remain constant, the stock market has more room to run.
What about the rest of the year?
Looking forward, analyst expectations are for earnings growth of 7.3 percent in the third quarter and 12.4 percent in the fourth. Here, we have to account for the fact that earnings estimates typically decline from initial levels to those at the end of the quarter, before then being exceeded. Even accounting for that, the rest of the year looks solid.
For 2017 as a whole, earnings growth estimates are at 9.8 percent. Given strong first-quarter growth of 14 percent and likely double-digit growth in the second quarter, along with growth close to estimates for the back half of the year, this should be achievable. Mind you, it's early, but the initial signs are very positive.
Is there anything to be concerned about? One potential issue is that much of the expected earnings growth comes from energy companies. Without that sector, earnings expectations drop from 6.6 percent to 3.7 percent. This is more of a concern for the third quarter rather than the second, where the numbers have already been booked. It is, however, a headwind for the rest of the year.
Overall, earnings season is looking strong and has a real potential for meaningful positive surprises. Earnings surprises were a major driver of stock market appreciation in the second quarter and have that potential for the coming third quarter as well.