Why Were So Many Earnings Beats This Season Followed by Share Price Drops?

In this Answers, Answers segment of this episode of Motley Fool Answers, Alison Southwick, Robert Brokamp and guest Morgan Housel (a former Fool now at the private equity VC firm The Collaborative Fund) consider the earnings expectations game: No company wants to merely meet expectations, and most investors want quarterly results that beat expectations. But if you expect to exceed expectations, what are your expectations, really? And how should those relative numbers guide Foolish investors' actions?

A full transcript follows the video.

10 stocks we like better than Wal-MartWhen investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, the Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the ten best stocks for investors to buy right now... and Wal-Mart wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of October 9, 2017The author(s) may have a position in any stocks mentioned.

This video was recorded on Aug. 22, 2017.

Alison Southwick: Let's get to the question for today, shall we? It comes from Edward in Australia. He writes, "This earnings season we've seen a fair bit of volatility, which is to be expected. However, I was surprised by the number of companies that released great or expected results and immediately dropped in value. Investors not being happy even with awesome results suggests to me that a company might be significantly overvalued and when we see it with heaps of large companies, does this mean the whole market is too overvalued?"

Morgan, when you were at the Fool you wrote many a column about quarterly earnings reports. How do you feel about Edward's question?

Morgan Housel: I always think there's an irony or almost an oxymoron that most investors expect earnings to beat expectations. And if you're expecting something to beat expectations ...

Southwick: You're like, "Wait a second."

Housel: It's like this weird game. The expected numbers of a company "beating their numbers" is a game that's not really rooted in like, "Oh, well you beat your numbers so this should be good for the stock." Those expectations don't really mean anything. It's effectively a made-up number that companies and analysts picked out of thin air. "We're going to earn $1.32 per share during this quarter."

Southwick: Why not $1.31?

Housel: Right. It's just the numbers, themselves, are kind of meaningless. But more important, your markets are forward-looking, so a company can beat its earnings expectations for the previous quarter. But if it gives any guidance on the future that sales are going to slow down, or blah, blah, blah, or maybe the CEO just had a tone in his voice on the conference call that made investors a little anxious; then markets can react in that way.

The bigger, more important point, though, is I think for any serious investor, both the quarterly earnings themselves and the reaction to quarterly earnings shouldn't play a big part in your outlook as an investor. That aspect of investing is, I think, a game that a lot of short-term traders play. And if you are a short-term trader then maybe, great, that's what you're looking for. But if you're a long-term investor it's really just noise.

Southwick: What about Edward's question [as to whether] the whole market is too overvalued? Do you think it's overvalued?

Robert Brokamp: Of course it's overvalued, but that doesn't mean it's going to drop tomorrow. For me overvaluation just means as a retirement planner what kind of returns [I can] expect from my savings so that I can see how much I'm going to have in 10 or 20 years so I know I can retire.

Housel: My only problem with something like that -- even though I, in theory, 100% agree with it -- is that every calculation that says when the market is valued at X then over the subsequent 10 years it should earn Y; none of those have a good track record. You can look backwards and piece together, and have like a hindsight is 20/20 vision of it, but every investor that has these fancy models that say since the market is overvalued [they] should do X with [their] money -- not back tested on the chalkboard but they're actual returns that investors earn -- are terrible.

Brokamp: Right.

Housel: So, I agree with you in theory, but I think it gets dangerous when investors say, "Because stocks trade at 22x earnings, I'm going to sell everything because that tells me they're overvalued."

Brokamp: Right, that's the tricky part. But from a retirement planning perspective, and as longtime listeners know, I love my retirement calculators. You have to put in an assumption for what you are going to earn, and when the market is highly valued, you should not expect to get that historical 10% over the rest of your life. I would say you put in closer to 5-6%. Hopefully you're wrong in the terms that you get upside surprise, but you don't want to count on double-digit returns from the stock market at this point to bail you out of your retirement.

The Motley Fool has a disclosure policy.