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How To Read an Earnings Report

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Traders and investors read a quarterly earnings report in completely different ways.

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Traders and investors read a quarterly earnings report in completely different ways.

A trader looks for every jot and tittle that could move the stock and generate a quick gain or prevent a loss, but an investor takes the long view and reads deep into the numbers, looking for trends.

"Investors should look for 'noise' in an earnings report," says Vitaliy Katsenelson, Minyanville professor, vice president and portfolio manager at Investment Management Associates. "A quarter is only 90 or 91 days and there may be random events or things in the report that have no long-term impact on the company's value."

Style vs. Substance

Remember the distinction between a company's news release about its earnings and required filings with the Securities and Exchange Commission. The news release frequently emphasizes flapdoodle and should be read with a skeptical eye. For example, it may stress record sales while burying key issues: increased expenses have eroded net income and knocked the stock's price/earnings ratio out of whack.

By contrast, the numbers are presented straight up in an SEC filing to comply with federal rules. Those who cook the books end up in prison like Bernie Ebbers, former WorldCom chief executive officer who dragged the company into bankruptcy while reporting stellar earnings to goose the stock.

So, read the company's news release for background but study its financial statements for the facts you need to make sound investment decisions.

Another caution: Wire services providing earnings reports for the general press routinely include year-over-year earnings comparisons, suggesting the crude measure of performance ranks right up there with stone tablets from the mountaintop.

Calculate earnings per share, or EPS, by dividing the company's profit by the number of outstanding shares. Warrants, stock options and convertible preferred shares can boost the number of outstanding shares. This can reduce the earnings per share: bad news for investors. It's unlikely that holders of warrants, options and preferred convertible shares will convert their holdings into common stock all at once, but there's a good chance the conversions will be made in the future. Therefore, a large difference between a company's EPS and diluted EPS suggests a high potential for dilution of the company's stock in the future. If so, investors and analysts are almost certain to turn thumbs down on the stock.

Take a Trip Down Memory Lane

An earnings report provides a snapshot of a company's performance that's meaningless without context. The smart investor therefore looks for a trend over several years. Do this by checking the company's filings with the Security and Exchange Commission, 10-Qs for quarterly reports and 10-Ks for annual reports. The reports are public record and available for free here. The information also may be available through the company's Web site. In short, a company's quarterly bottom line doesn't tell you all you need to know when sizing up a company.

To put the current quarter in context, go back at least two years, but many analysts recommend comparing the current quarter's earnings with at least the prior 12 quarters, or three years.

Keep in mind that it's not a big deal when a company beats analysts' estimates. Smart CEOs routinely understate current prospects so they can trump estimates and polish their standing as genius-in-residence.


Corporate earnings have a fun side too! Don't miss Hoofy & Boo's take on the matter in The Earnings Parade. Also make sure to check out Prof. Macke's assessment of Starbucks' past earnings in The Search for Starbucks' Soul.


Use Percentages for Perspective

Here's an inside baseball trick that will make your analysis easier: convert the numbers displayed in the company's income statement into percentages so each item represents a percentage of revenue. This will make it easier to make quarter-to-quarter and year-to-year comparisons of earnings and spot trends.

"You want to identify value drivers," Katsenelson says. "For a retailer, look at same store sales, margins, inventory turnover and store traffic. This is a good way to spot potential problems."

To Each Their Own

In short, the entries above the bottom line tell the tale when sizing up a company's future prospects. But remember a sector's quirks: Retailers typically build inventory in the third quarter as they prepare for the holiday rush and draw it down in the fourth quarter of the calendar year as shoppers stampede the malls. Other industries are cyclical – home building and home improvement typically show strength in the spring and summer, but slow during the fall and winter. The tax preparation folks make their hay prior to April 15th.

For manufacturers, keep an eye on gross profit margin. Fancy footwork can't obscure a declining gross profit margin. Next, check operating income. An increasing operating income margin and a declining gross profit margin will provide a short-term boost, but nothing more. In that case, it's a good bet that the company is cutting key marketing and research and development activities to the detriment the company's of future. The flip side: increasing profit margins and falling operating income may reflect sound investment in the company's future.

And In This Corner

Be sure to put the numbers in context with the company's competition to gauge performance with its peers. Without this step, the numbers exist in a vacuum. The key is selecting comparable companies. Coca Cola (KO) and Pepsico (PEP) seem like a good match, but are sharply different operations. Coke has extensive overseas sales and Pepsi generates significant revenue from snacks. Moody's (MCO) and Standard & Poor's provide similar services, but the latter is part of The McGraw-Hill Companies (MGH), a large and diversified publisher.

Moral: Compare segment to segment – not overall bottom lines – when sizing up performance of large, diverse companies.

Keep an eye on one-time charges that are disclosed in quarterly earnings reports as needed. The section should be a discussion of expenses unlikely to occur in the future, but can be a convenient dumping ground for mistakes or even a way to hide expenses. If the section degenerates into a laundry list quarter after quarter, it could mean future earnings will be weak.

Do Your Homework

The shrewd investor sharpens a pencil and reads deeply into the company's quarterly 10-Q statement filed with the SEC. This gives them a leg up on the lemmings.

"It's easy to react to the 'noise' in a quarterly earnings report," Katsenelson says. "Wall Street does it all the time."
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No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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