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How to Interpret Earnings Reports

 Joel Anderson, Equities.com

July 18, 2018

There’s a lot that factors into investing. At times, the way stocks seem to move up and down without necessarily correlating to anything in particular can be frustrating. However, four times a year, every company, whether it be a hot tech stock that has yet to actually turn a profit or an aging utility company sluggishly crawling along, has to face the music. Earnings reports, issued quarterly along with a full-year report in the fourth quarter, are the moment when public companies open up the books and let the world know how they’ve been doing.

In many ways, the earnings report is one of the greatest features of the whole system of public ownership. A public company belongs to its shareholders, and as a result, it’s legally obligated to maintain a certain minimum level of transparency in its finances. Whether you’re a pensioner clinging to one share you scraped together the money to buy or a billionaire with a controlling share in the company, you’re on equal footing at least four times a year.

They’re also the measuring stick by which companies ultimately get measured. Sure, a lot of companies can pile up losses for years and see their stock keep gaining as long as the promise behind their product is enough, but sooner or later, you have to show results. Stocks can, at times, seem frustratingly disconnected from the actual business of making money, but the earnings report is the promise that, in the long run, the rubber always meets the road.

So, here’s a quick primer on how to interpret the earnings reports that come flooding in four times a year.

How Much Money is Coming in, and Where is it Going?

On a basic level, an earnings report simply releases the basic income statement and holdings of a company. It doesn’t include everything. Plenty of companies will elect to include or not include certain figures based on market expectations or their own desire for propriety. However, what’s always there are the nuts and bolts on which a company’s valuation is built.

Unfortunately, corporate accounting tends to use a wall of opaque language to describe precisely how the money comes in and goes out of a company. Digging into precisely which numbers matter most to which companies in which industry can leave you drowning in a pretty dizzying array of figures. You can dig into what a lot of these different phrases mean here, but simply understanding the terminology is arguably less important than getting the bare bones and knowing how the market will interpret them.

If nothing else, two figures matter more than everything else: revenue and net income. Revenue is how much money is coming in, net income is essentially how much of it the company keeps after all the expenses are paid. For young companies early in their life cycle, a total lack of profits is often overlooked as long as the revenue is great, with investors assuming that a fast-growing company will work out the kinks eventually. For older companies, net profit is going to mean a lot more, with the ability to actually book profits and potentially increase their dividend or buyback stock being more appealing.

Companies will also issue “guidance,” which is their best estimate as to how the next quarter or year will go in terms of revenues and profits. These can also be very important as they give the most specific insight into the company’s own outlook as to where their business is headed.

However, it’s not just those numbers, it’s the context they arrive in.

Forget Profit, Look for Growth

The numbers themselves are only so important. It’s how they compare to the numbers from the year before that tends to get the stock moving. Seasonality can frequently mean comparing numbers from one quarter to the next is pretty much useless. Retail stocks, for instance, are always going to have their biggest numbers in the fourth quarter, so a big jump from Q3 to Q4 doesn’t mean much. However, if your Q4 is a big improvement on the Q4 from last year, it’s a sign that things are improving.

And growth is what really matters. How the numbers compare to the year before, or the five years before are what really tell the story of where a company is. More importantly, it’s what the market will react to, which is what really matters in terms of share price.

So, as much as revenue and net profit matters, it’s the year-over-year growth that matters more. So, not only is the comparison between last year’s revenue and this year’s revenue essential, but the comparison of the percentage increase in year-over-year revenue to last year’s percentage increase in year-over-year revenue.

That can seem a little self-reflexive, but it’s a pretty powerful indicator for the way a company’s prospects are headed, articularly for companies early in their lifecycle. That patience investors often have in a young company that’s building itself dries up pretty quickly once the growth rate in its revenue starts to slow down. At that point, not unlike someone who just got out of college, you better start improving margins and turning a profit.

It can vary a lot based on the industry, as well. Certain businesses are very steady, with the difference between a good quarter and a bad one being pretty marginal. Others will have wildly different earnings reports from quarter to quarter or year to year. Some industries feature incredibly high volume and very low margins, others don’t sell a lot of stuff but book huge profits on what they do find buyers for. Understanding the specific nature of the industry a company’s in is pretty essential to knowing what to think of an earnings report. Simply taking the raw numbers from Wal-Mart’s (WMT) Q2 report and Exxon Mobil’s (XOM) Q2 report and comparing them isn’t going to tell you much about either company. Compare Exxon Mobil’s Q2 numbers with Chevron’s (CVX), though, and you’re getting somewhere.

Earnings are Up, Value is Down… What Happened?

Perhaps the most consternation you’ll hear about earnings reports surrounds the way analyst expectations seem to confound even the strongest results. You own stock in a company that comes out with an earnings report that simply crushes it, boosting revenue and profits by the most in several years. You log onto Equities.com ready to see the stock’s price climbing and it’s down. What?! You read in an article that the profit and revenues were both below “analyst expectations.”

So who are these analysts?! How can these people’s “expectations” matter more to your shares than the killer quarter they just put up?

Analysts are an army of financial experts who spend their time digging into every detail about a company, usually employed by a variety of investment banks. They tend to offer up what they anticipate a company’s profits or revenue will wind up being.

However, it’s not so much the expertise of these people that matters. What’s really important about these estimates is that they represent the prevailing market sentiment. When it comes to stocks, what really decides how much a company is worth is market sentiment. In order to sell shares at a certain price, someone has to be willing to buy them at that price. So, no matter how “well” a company is doing, if the general perception is that it’s not doing well enough, the stock price will go down.

It’s also important to remember that the price prior to the earnings is also based on those analysts’ expectations. Those estimates are the best guesses at how strong a company’s quarter has been based on the incomplete data available, while the price the first trades after the data reflect the price based on what people now know for sure.

There’s also guidance to consider as well. No matter how well the company’s last quarter went, if they’re anticipating a down year next year, you can bet that will negatively impact the stock. That may seem unfair, but remember, the market tends to be extremely forward looking. If a great quarter is a part of an ongoing trend, then it’s growth. If a great quarter is the beginning of a plateau, or worse, a high point from which numbers will decline, the market sentiment is likely going to turn sour.

So, if a company has a great quarter but still underperforms expectations and sees shares drop, it’s important to remember that the stock’s price was artificially high prior to the report. In the weeks leading up to the actual release, people were paying a price for the stock based on the expectations people had prior to that earnings report. So, if the report comes out and it’s worse than those expectations, no matter how good the report is on the whole, the market will still correct some to reflect the new reality in that report.

This can be a touch frustrating if you’re just checking in a few times a year, but odds are if you check the stock’s performance over the last few months or the last year, if the company’s really been booking solid profits their share price will reflect it even if there’s a downward correction the day after the earnings release.

Trusting Market Rationality… It’s Only Rational

There’s never any guarantee that the price of shares in a company will adhere rationally to what they should. Market sentiment can, at times, remain frustratingly out of line with what some believe to be the most logical conclusions about a company. As John Maynard Keynes once said, “Markets can remain irrational far longer than you and I can remain solvent.”

However, over a long enough period of time, earnings reports are the tangible connection to reality that tends to boost solid companies that are underperforming and bring high-flying stocks crashing back to earth. The numbers contained within these quarterly reports represent a sobering reality. So, while the markets tend to be chaotic and reactive in the short term, the raw data these companies churn out over time tends to make them much more predictable in the long term.

So, if a retail investor focuses solely on those companies that tend to show the most consistent results in their earnings reports, it’s pretty hard to go wrong in the long run.

 

Written by Joel Anderson from Equities.com

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