Investment word of the day: Earnings momentum — how is it calculated and what are its drawbacks? All you need to know

Investment word of the day: The earnings of a company are the first metric that investors check before investing. Whether you are a beginner or an expert, earnings are a significant indicator that can help you make investment decisions. However, it is also important to understand how the earnings have performed over a period of time, which can be determined by earnings momentum.

What is earnings momentum?

Earnings momentum highlights trends in a company's earnings. When a company's earnings increase over a period of time, it reflects positive earnings momentum, while when it declines, it is referred to as negative earnings momentum.

Earnings momentum is typically calculated quarterly or annually. It highlights a company's growth in profitability.

How earnings momentum is calculated

Earnings momentum is measured by calculating the percentage change in earnings per share (EPS) over a period of time. It is determined by comparing a company's current EPS growth rate to its previous EPS growth rate, reflecting change in the rate of earnings growth.

When does earnings momentum become important?

“Earnings momentum is most effective for large-cap growth stocks in bullish phases of earnings cycles when they tend to outperform speculatively. Moreover, with the onset of the earnings season, it assists in determining for which stocks the institutions are increasingly bullish,” according to Siddharth Maurya, Founder and MD, Vibhavangal Anukulakara.

Drawbacks of earnings momentum

Simply relying on earnings momentum has several shortcomings. Earnings momentum may mislead regarding a company's true performance in the long run especially due to temporary business or external shocks and unusual business conditions, as per Maurya.

“Moreover, excessively high earnings momentum can result in much higher expectations and theoretically force the securities of the company into a much riskier situation,” the expert said.

“An additional critical issue relates to the effect of external shock events, such as an economic recession, a modification in interest rates, or new regulations, which may suddenly stop a firm’s earnings expansion even with strong historical results,” he added.

Investors need to reconcile earnings momentum with underlying analysis, paying attention to revenue consistency, debt, and market share to make wiser investment decisions.