Watch how the value of something you own, such as your first house, can experience some unexpected ups and downs, and you have a handle on volatility. Essentially, volatility is a measure of risk -- and when a company's profits, which are another way of characterizing earnings, are unpredictable, so too are the returns that investors are likely to earn. Earnings are often a driver of stock performance, and as a result unstable earnings performance doesn't generally bode well for investors.
You can't tell if a company's earnings are volatile by looking at quarterly results alone; you've got to compare the outcome to some other barometer. Generally, earnings are compared to performance from the year-ago period and also corporate management and financial analyst estimates. Earnings projections can also prove volatile: In the second quarter of 2013, companies in select industries were lowering earnings guidance and, in response, analysts slashed their profit growth expectations by 80 percent, according to a 2013 report on research firm Fact Set's website.
It's not uncommon for investors to build trading strategies based on a company's valuation, which represents the way a stock is valued in the market based on its perceived earnings potential. Growth investors hunt stocks that are clearly growing their profits, while value investors look for companies whose stock prices don't yet reflect the true earnings potential. The level of earnings volatility has a direct effect on a company's valuation. According to a 2011 article on the CFA Institute website, volatile earnings help growth stocks but hurt value stocks.
Earnings can be volatile for many reasons. Companies whose profits are tied to the state of the economy, such as retailers, could produce unpredictable results when the economy slows and consumers aren't spending on brand-name items like they normally do. Food companies could produce volatile results when the price for commodities, such as grains and produce, rise and costs go up. In 2013, policymakers sought to revamp the accounting standards insurance companies used for reporting various types of insurance contracts. If adopted, the change was expected to lead to volatile earnings from one quarter to the next among insurance companies and other financial institutions.
Online retailer Amazon.com proves that earnings volatility doesn't always predict stock returns. In the fourth quarter of 2012, Amazon's earnings were actually worse than they were in the previous year's corresponding period. Nonetheless, investors piled into the stock and shares rose 8 percent on the news, according to a 2013 Wall Street Journal article. In that earnings report, the company predicted that in the following quarter, it would either report a profit or a loss. Despite the volatile earnings prediction, the stock rose higher.
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