Earnings momentum

What Is Earnings Momentum?

Earnings momentum refers to the rate at which a company's reported or projected earnings are increasing or decreasing over a specific period. It is a key concept within quantitative investing and broader financial analysis, as it provides valuable insights into a company's financial trajectory and potential for sustained growth³⁷, ³⁸. Positive earnings momentum signifies a consistent increase in earnings per share (EPS) or overall corporate earnings, while negative momentum indicates a decline³⁵, ³⁶. Investors often consider earnings momentum to gauge a company's fundamental strength and assess its attractiveness for investment decisions.

History and Origin

The concept of earnings momentum is deeply intertwined with the development of quantitative finance and the study of market anomalies. Early academic research laid the groundwork for understanding how markets react to new information, particularly earnings announcements. In 1968, researchers Ball and Brown highlighted that stock prices do not instantaneously adjust to earnings news, but rather exhibit a gradual "drift" in the direction of the earnings surprise, a phenomenon later termed the Post-Earnings-Announcement Drift (PEAD)³³, ³⁴. This observation suggested that market participants might underreact to new information, creating opportunities for strategies that capitalize on this delayed price response³¹, ³².

The systematic study of factors like earnings momentum gained prominence with the rise of computing power in the late 20th century, enabling more sophisticated portfolio management and data analysis²⁹, ³⁰. Pioneers in quantitative finance began to develop models that incorporated various factors, including earnings-related data, to predict future stock performance. The evolution of this field, which applies mathematical and statistical methods to financial markets, has a rich history, with foundations stretching back to works like Louis Bachelier's "Theory of Speculation" in 1900, which applied mathematical principles to financial markets. More on this historical trajectory can be explored through resources like "A history of quant" published by Federated Hermes.²⁸

Key Takeaways

• Earnings momentum measures the rate and direction of a company's earnings changes, offering insight into its financial health and future prospects.
• It is a dynamic indicator that considers both the magnitude and acceleration of earnings growth or decline.
• Positive earnings momentum often suggests a financially healthy and growing business, potentially signaling continued strong performance.
• Investors and analysts use earnings momentum as part of a broader valuation and analysis process, not as a standalone metric.
• The phenomenon of earnings momentum is linked to market inefficiencies, such as the Post-Earnings-Announcement Drift, where stock prices exhibit a delayed reaction to earnings news.

Formula and Calculation

Earnings momentum is typically measured by assessing the change in a company's earnings per share (EPS) growth rate over successive periods. While there isn't one universally standardized formula, a common approach involves comparing the current period's EPS growth to previous periods' growth to identify acceleration or deceleration.

One way to think about earnings momentum involves the change in the growth rate of EPS. For example, if a company's EPS grew by 5% in Year 1, 10% in Year 2, and 15% in Year 3, this indicates accelerating earnings momentum²⁷.

A more formalized approach might involve calculating the percentage change in EPS over time, such as quarter-over-quarter or year-over-year, and then observing the trend of these changes.

Consider the following simplified representation of a change in EPS growth rate:

Where:

• (\text{EPS Growth Rate}{\text{Current Period}}) = (\frac{\text{EPS}{\text{Current}} - \text{EPS}{\text{Previous}}}{\text{EPS}{\text{Previous}}})
• (\text{EPS Growth Rate}{\text{Previous Period}}) = (\frac{\text{EPS}{\text{Previous}} - \text{EPS}{\text{Two Periods Ago}}}{\text{EPS}{\text{Two Periods Ago}}})

This calculation helps identify if the profitability trend is strengthening or weakening.

Interpreting the Earnings Momentum

Interpreting earnings momentum involves more than just looking at a single number; it requires understanding the context and direction of a company's earnings trajectory. Positive earnings momentum, where earnings are not only growing but growing at an accelerating pace, is generally seen as a bullish signal. It suggests that a company's underlying business is strengthening, potentially leading to increased shareholder value. Conversely, negative earnings momentum, where earnings are declining or their growth is decelerating, can indicate underlying business challenges.

Analysts and investors use earnings momentum to assess the sustainability of a company's growth potential and to compare it against industry peers²⁶. A company with consistently strong earnings momentum might be viewed more favorably than one with erratic or decelerating earnings, even if their current EPS figures are similar. It reflects the dynamic aspect of a company's performance, much like how a physicist considers the direction and acceleration of an object, not just its velocity²⁵. This dynamic perspective helps in making more informed investment decisions.

Hypothetical Example

Consider two hypothetical companies, TechCo and RetailCorp, both with current EPS of $2.00.

TechCo:

• Q1 EPS: $1.50
• Q2 EPS: $1.75 (16.67% growth from Q1)
• Q3 EPS: $2.00 (14.29% growth from Q2)

RetailCorp:

• Q1 EPS: $1.00
• Q2 EPS: $1.40 (40.00% growth from Q1)
• Q3 EPS: $2.00 (42.86% growth from Q2)

While both companies have the same current EPS, RetailCorp exhibits stronger earnings momentum. Its EPS growth rate has accelerated from 40% to 42.86%, indicating increasing strength in its financial performance. TechCo's growth, while positive, has decelerated from 16.67% to 14.29%. An investor focusing on earnings momentum might view RetailCorp as having a more favorable near-term outlook due to its accelerating profitability trend, even if TechCo's business fundamentals appear stable. This analysis complements other forms of financial analysis for a comprehensive view.

Practical Applications

Earnings momentum is a widely used factor in investment strategies, particularly in the realm of quantitative analysis and active portfolio management.

• Stock Selection: Investors often screen for companies exhibiting strong positive earnings momentum, believing that past trends in earnings growth can continue into the future²⁴. This approach is common in growth investing strategies.
• Analyst Forecasts: Professional analysts closely monitor earnings momentum when revising their future earnings forecasts. Significant shifts in a company's earnings trajectory can lead to updated recommendations and price targets.
• Risk Management: Negative earnings momentum can serve as an early warning sign for deteriorating financial health, prompting investors to re-evaluate their positions or implement risk management strategies.
• Economic Indicators: At a macro level, aggregate corporate profits are a significant economic indicator that reflects the overall health of the economy²³. Agencies like the U.S. Bureau of Economic Analysis (BEA) regularly release data on corporate profits, providing crucial insights into economic performance. This data is accessible through official sources like the BEA's website.²²
• SEC Filings: Publicly traded companies are required to disclose their financial information, including earnings, in various filings with the U.S. Securities and Exchange Commission (SEC). The SEC's EDGAR database provides public access to these financial statements and reports (e.g., 10-K, 10-Q), which are essential for calculating and verifying earnings data. The SEC EDGAR database is a key resource for this information.¹⁹, ²⁰, ²¹

Limitations and Criticisms

While earnings momentum can be a powerful tool, it has several limitations and criticisms that investors should consider.

• Lagging Indicator: Earnings are historical data points, meaning earnings momentum is inherently a lagging indicator. By the time strong or weak momentum is confirmed, the market may have already begun to price in the trend.
• Sustainability: Past earnings momentum does not guarantee future performance¹⁸. A company might experience a period of strong earnings growth due to temporary factors, such as a one-time sale or an industry-specific boost, which may not be sustainable¹⁷.
• Market Volatility: Stocks with high earnings momentum can be popular and attract significant investor interest, potentially leading to higher market volatility and greater price fluctuations¹⁶. This can make timing investments more challenging and increase the risk of losses during market downturns.
• Over-reliance: Solely relying on earnings momentum without considering other fundamental factors, such as a company's competitive landscape, management quality, or overall market conditions, can lead to misguided investment decisions¹⁵.
• Behavioral Biases: The persistence of phenomena like the Post-Earnings-Announcement Drift (PEAD) is often attributed to investor behavioral biases, such as underreaction to new information or confirmation bias¹², ¹³, ¹⁴. This suggests that earnings momentum strategies might exploit temporary market inefficiencies rather than fundamental value. Critics argue that while PEAD has been a documented anomaly, its existence at disaggregated levels and its consistent profitability can be debated, and that relying on it solely can be misleading¹¹. Concerns about the limitations of earnings momentum in assessing true long-term performance are highlighted by financial experts.¹⁰

Earnings Momentum vs. Price Momentum

Earnings momentum and price momentum are two distinct but related concepts often used in investment strategies. While both fall under the broader umbrella of momentum strategies, they focus on different underlying drivers of stock performance.

Earnings momentum centers on the trend in a company's fundamental profitability as reflected in its earnings reports, typically measured by the growth rate of earnings per share (EPS). It indicates whether a company's core business performance is accelerating or decelerating over time⁸, ⁹.

Price momentum, on the other hand, refers to the trend in a security's stock price over a period, irrespective of the underlying earnings. It suggests that stocks that have performed well recently in terms of price tend to continue performing well, and vice-versa⁶, ⁷.

The key distinction lies in their source: earnings momentum is driven by changes in a company's actual financial results, whereas price momentum is driven by investor sentiment and trading activity that manifests in stock price movements. Although a company's earnings can influence its stock price, other factors like broader market sentiment and industry trends can also significantly impact price momentum⁵. While some research suggests that earnings momentum may explain or even subsume price momentum, other studies indicate that both factors can offer unique insights into a firm's prospects, and that both have predictive power for future returns¹, ², ³, ⁴.

FAQs

What does positive earnings momentum mean?

Positive earnings momentum means that a company's earnings are consistently increasing, and often, the rate of that increase is accelerating. This is generally seen as a sign of strong and improving financial health.

How is earnings momentum different from earnings growth?

Earnings growth simply refers to an increase in earnings from one period to the next. Earnings momentum, however, focuses on the trend of that growth, specifically whether the growth rate is accelerating or decelerating. A company can have positive earnings growth but negative earnings momentum if its growth rate is slowing down.

Can earnings momentum predict future stock prices?

Earnings momentum is often used by investors as an indicator that may suggest future stock price movements, as companies with accelerating earnings tend to attract more investor interest. However, it is not a guarantee, and many other factors influence stock prices. Market efficiency and investor reactions play a role in how earnings news translates to price movements.

Why is earnings momentum important for investors?

Earnings momentum provides investors with a dynamic view of a company's operational performance beyond just static financial statements. It helps identify companies with improving fundamentals that could potentially lead to sustained financial strength and positive returns. It's particularly useful for those employing quantitative strategies or looking for growth opportunities in equity markets.

What are the risks of investing based solely on earnings momentum?

Relying solely on earnings momentum carries risks such as potential short-term focus, higher transaction costs due to frequent trading, and susceptibility to market volatility. It may also lead to insufficient portfolio diversification and does not inherently protect against sudden negative events or changes in a company's underlying business. Many critiques of momentum strategies, particularly from a behavioral finance perspective, suggest that they may be exploiting short-lived market inefficiencies rather than fundamental value.