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In a post previewing today’s Apple earnings announcement, NYU finance professor and valuation expert Aswath Damodaran examined how stock prices react to earnings announcementsDamodaran identified four ways that investors can trade the average 2 to 3 per cent drift in stock prices after an earnings surprise:
1. Predict the surprise
This is difficult to do with publicly available information, but you can attempt to forecast earnings surprises ahead of announcements. Anything from trading volume to price patterns can be a possible advance indicator from which you can profit.
2. Trade on the news
Buy stocks on a large earnings beat, or go short on a stock that has missed badly. This is unlikely to do much other than increase returns at the margin given the usual size of earnings drift, though you could “load up and use options to leverage the profits”.
3. Earnings momentum
This is a longer term strategy. Companies that beat earnings estimates several quarters in a row have a tendency to offer higher returns in the future. Besides looking for high quality growth and low risk, screening for earnings momentum can also be valuable.
4. Intrinsic value
After an earnings announcement, look past the surface number (earnings per share) and at things like operating margins, return on capital, and revenue growth. In some cases, while the headline number might look good, there might be negative news beneath the surface to justify shorting a stock after a post earnings jump.
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