Earnings season is always hotly anticipated. This half-yearly beauty contest provides long-term investors the opportunity to overreact to short-term results while traders try and profit from guessing the direction of this overreaction. At Morningstar, our analysts pay close attention to earnings, but the focus is on long-term results and valuations. A single earnings report usually doesn’t lead to a change in the long-term assumptions behind our assessment of a stock’s fair value, unless a company also comes out with new, material information that change our long-term assumptions. For example, new data on a drug that raises the probability of approval, or pricing gains in a key product line could affect an analyst’s long-run thinking.

The paradox of being an investor is that the only thing that matters is what a company achieves in the future. Yet all the information we have is historic. Many investors, including the surge of new market participants since 2020, place outsized importance on earnings season as it shows how companies, and their investments, performed. Although interesting, it defeats the purpose of investing, as we should not place emphasis on what happened in the past. Our focus should remain on the future. After all, we purchase shares not for their past performance or results, but for their future potential.

At Morningstar, we believe the real opportunities for investors occur when the short-term reaction to an earnings announcement is not in line with the long-term value of a company. Changes to our fair value estimates for a company can provide context to price movements.

One example is Bendigo and Adelaide Bank (ASX:BEN). Our Morningstar analysts do not believe that the earnings changed the outlook for the underlying business and maintained our fair value of $10.20.

Before going into Bendigo and Adelaide Bank specifically, we need to understand bank earnings. At the core of any analysis of a bank is the fact that they primarily profit from lending money out to people and businesses and charging interest for that. They can source those funds from two primary places and both have costs. One is from customer deposits, and the cost there is the amount of interest they pay you. The other is from going out and borrowing it themselves, where they have to pay interest.

At a high level, the difference between those two numbers is what a bank makes. This is called the net interest margin and it is one of the most important measures of bank profitability.

To get a deeper understanding of net interest margins, you can listen to our share deep dive of Westpac (ASX:WBC) on Investing Compass.

In the current environment where interest rates are going up, the net interest margin will generally also go up which means that banks are more profitable. Banking is one of the few industries out there that generally perform better in a rising interest rate environment. The reason for this is because they are generally quicker to pass along those increases in interest rates to customers than they are to pay them out to depositors.

This seems like the perfect time to invest in a bank - interest rates are clearly going up and banks will be more profitable. How much banks make on the loans are important, but loan volumes are also critical. So while interest rates going up may make each loan more profitable, it can also impact the volume. The whole point of a central bank increasing interest rates is to slow an overheating economy. Right now it is to significantly slow an overheating economy as we are facing the highest levels of inflation in a generation. In a growing economy, consumers and businesses are borrowing money and spending as they’re more comfortable taking on debt in economies that are going well.

Let’s turn back to Bendigo and Adelaide Bank. ASX: BEN is one of Australia’s top 10 largest banks, but it’s 10 times smaller than the four major banks. It has a higher cost to income ratio and funding costs, and that means that it’s difficult for them to generate attractive returns on shareholder capital in a competitive market. They’ve acquired smaller banks to diversify, scale and compete – that includes Adelaide Bank, Rural Bank and Delphi Bank. This has diversified and scaled the loan book but to date it has failed to generate excess returns on equity given a larger capital base.

When we look at earnings, the main influences are modest credit growth, pressure on funding costs and intense lending competition. All of these factors influence the net interest margin.

ASX:BEN achieved better loan growth than our analyst Nathan had forecasted, up 8%, but it came at the expense of margins – the net interest margin for BEN declined 21 basis points to 1.74%.

And this was because of the intense competition in this space – without scale, it is difficult to maintain those margins and sustain them. Alongside competition, there was higher than usual client demand for fixed rate loans, repricing of older loans and because of regulation, having to hold more liquid assets. And all of these combined together really just outweighed the benefit of the cheap customer deposits they’ve enjoyed because of low interest rates.

When we look at net interest margin or NIM, from January to June, was 1.69%. But looking at June, it averaged 1.73% and those are early signed of the NIM improving from higher rates. We think this will continue to improve in 2023 and forecast 1.8% in the next fiscal year.

So in Nathan’s opinion, the NIM looks healthy and will continue to grow – his fair value for BEN remains unchanged at 10.20. And this is not what investors saw in the earnings result. The decline in NIM, as well as the pressures on that margin caused the market to take a pessimistic view of BEN’s outlook.

After earnings were announced on the 15th of August, we saw the market react by selling out of BEN, sending the stock down 15% to 30 August 2022. Nathan doesn’t believe this is justified and does not believe that the announcement fundamentally changed the value of the company.

It’s important to remember that earnings season is just a snapshot into historical results of a company. It does not take into consideration future prospects, or future earnings – and this is what you are interested in as an investor purchasing a company. In this case, investors may be focusing too much on historical NIM instead of how it is trending, and how rising rates may continue this trend. Overall, we believe that it’ll be net positive against the rising operating costs.

Ultimately, this pessimism created from short term, historical results has opened an attractive buying opportunity for investors.