LEVEL: BEGINNER
Earnings are a fundamental part of the business world and are the focus for equity and debt investors around the world. The report is more important than the headline number a company will publish along with its other financial statements (balance sheet, cash flow, and income statement). Understanding how to decipher a quarterly earnings report will be one of the most important tasks you can do when getting started investing.
You may hopefully be familiar with the Form 10-Q, which is the form that public companies must submit to the SEC on a quarterly basis. Typically these start with a “Note about Forward-Looking Statements” that serves as a sort of disclaimer about the particular risks a business may face in the future. After that, the form gets very technical.
Balance Sheet
The balance sheet will be the first technical item you will be exposed to that has information about the company’s assets and liabilities. One of the most fundamental relationships to understand is that Equity = Assets minus Liabilities. How a company decides to break down each of these into more detail will vary by industry. For example, a software company is much more likely to have a smaller inventory under current assets than an industrial firm would have. Keep that in mind as you start to build a portfolio of companies from different sectors.
Income Statement
The income statement is arguably the most important part of the entire report as it shows where and how much a firm makes. Typically it starts by listing total revenues and then breaks down the costs/expenses in a little more depth. There will always be a cost of revenues, a research and development, and selling, general and administrative expenses line. These will also vary by industry as well, depending on the type of product or service they are marketing.
Cash Flow Statement
The cash flow statement is the last piece of the equation and the final way to reconcile all of the financial statements. It is important to note that cash is not earnings and vice versa. Cash can be generated from 3 different sources – operations, investing, and financing.
Cash from operations is usually what results from earnings, but the goal of a company is not just to make earnings and translate that into cash. Likewise, cash does not go directly into expenses like expanding the business. If a company makes a purchase to buy a new facility, this will not come out of earnings – it will show up as a debit on the cash from investing activities within the cash flow statement. That investment, however, may eventually cause a positive or negative change in earnings.
Analyst Response
Analysts who pour over all these financial statements in depth create an outlook about a company based on trends in earnings, investments, financing, and so on. They then provide allocation recommendations that express their fundamental opinion for the company. Analysts will usually say that a stock is “underweight” or “overweight”. These have two meanings, depending if they apply to portfolios or stocks.
When a portfolio is underweight in a particular equity, the analyst is saying that the portfolio needs more of that equity. Overweight portfolios have too much of that equity, and should sell it. When a stock is overweight, that means it will perform better than the industry, and should be bought. Underweight stocks, however, will perform worse than the industry, and should not be bought or should be sold altogether.
Another variation of the system is when they provide the timing recommendations: buy, sell, and hold. Commentary by an analyst can also cause a serious move in the stock. Recent releases by firm Muddy Waters Research have seriously damaged several equities, for example.
Also it is important to see how a group of analysts project a set of earnings for a company. This can lead to serious volatility in the market when a company releases earnings. In many cases, the market will actually change its opinion as analysts dive into the 10-Q overnight and see if it is fundamentally different from the company’s initial press release. There are plenty of incidents when a stock will spike in the after hours session only to gap down in the morning as traders compare the 10-Q to the initial press release.
Earnings Calls
Earnings calls have been enhanced by technology as of late and still are an integral part of understanding a report in a nutshell. The first part of the call is a prepared statement that breaks down the quarter’s results in a fair amount of detail. CFO’s will end typically with guidance before diving into a Q&A session with investment bank analysts who want further information on something. As mentioned before, guidance is what a company internally projects the next quarter’s (and even lengthier periods) results should be. Typically, you will only see revenue and earnings get a projection.
For understanding how reliable a firm’s internal projection may be or how well an analyst has done in the past, it is important to look at historical performance. Benjamin Graham, the man behind Warren Buffet’s investment philosophy, had certain “rules” related to earnings:
- They should have earnings growth over the most recent 10 years of seven percent
- They should not have earnings decline more than 5 percent over the prior year
In short, these are based on the idea that companies should expand and deliver on their promises. If a CFO says consistently quarter after quarter that they estimate EPS being XYZ and it turns out to always be slightly less, there is a problem. You can look at past 10-Q filings to see how reliable management is at forecasting and this will help your analysis dramatically.
There are an incredible amount of detail that goes into an earnings report and it is easy to get overwhelmed, especially as a new investor. The more you start to look over 10-Q and 10-K forms and develop your own methodology, the clearer the process as a whole will become.