Earnings season is judgment day for stocks. It happens four times a year, after the last month of each quarter (March, June, September, December), as public companies release their earnings results from the previous quarter. Traditionally, Alcoa (AA)’s results "kick off" the season, and away we go.
Federal securities laws require companies to disclose revenue and earnings in a standard format that gives investors a view of its financial position—a report card of sorts—this info isn’t always the easiest for the average investor to decipher and tell exactly what a company is trying to say—or trying not to say.
But that doesn’t mean that this is rocket science. If you can read the side of a cereal box for its nutritional facts, then you can read a financial statement. And there are a handful of important numbers that will be able to tell you the financial health and growth of a company in a few short minutes.
First, let’s take a look at the three most important aspects of a financial statement.
Financial Statements Made Easy
An income statement will show you two things—how much a company earned for the year or quarter, and how much it spent in earning that revenue. When reading an income statement, start at the top, then go down each number and subtract the expenses until you reach the "bottom line," which will tell you how much the company earned (or lost) over the period.
The first number is usually labeled gross revenue or net sales. This is the total amount of revenue brought in from the sale of product or services.
Next we have to subtract expenses. First is the cost of sales—what the company spent in creating goods and services. We also subtract operating expenses like research, marketing or administration, as well as depreciation of assets, which takes into account the wear and tear on long-term assets like machinery during the time period. And finally, we have to account for interest income and interest expenses, as well as taxes that need to be paid.
After all these expenses are deducted, we arrive at the bottom line—net profit or net losses, which will tell you whether the company made or lost money.
This is also where we get the all important earnings per share, or EPS. This is just the total net income of the company, divided by the number of outstanding shares. EPS tells you how much money shareholders would receive for each share of stock they own if the company distributed all of its net income for the period.
A company’s balance sheet will tell you all about a company’s assets, liabilities and shareholder equity. Assets have to equal the sum of a company’s liabilities and equity.
First up, we have assets. These are all the things that a company owns in order to operate its business that have value—physical property like plants, trucks, equipment and inventory, as well as intangible assets like goodwill, trademarks and patents.
On the other side of the balance sheet are liabilities—financial obligations that the company owes. This can be money borrowed from a bank, rent for a building, money owed to suppliers, payroll for employees or taxes owed to the government.
Finally, shareholder’s equity—sometimes called capital or net worth—is money that would be left if a company sold all of its assets and paid off all of its liabilities. If, at the end of the year, a company reinvests its net earnings into the company, the earnings will be transferred onto the balance sheet into the shareholder’s equity account. Other times, a company may choose to distribute earnings through dividends instead of retaining them.
And I have to say, although I will never recommend stocks solely based on dividends, the yield of a company is indeed a factor I look at.
A cash flow statement shows how a company is paying for its operations and future growth by detailing how cash "flows" back and forth from a company. No business can survive for long without generating positive cash flow per share for its shareholders. As such, a company’s long-term cash inflows need to exceed its long-term cash outflows.
Often, cash flow statements are divided into three main parts: Operating activities reconciles the net income with the actual cash the company received from or used in its operating activities. Investing activities shows the cash flow from all investing activities, which generally include purchases or sales of long-term assets. And finally, financing activities includes cash raised by selling stocks and bonds, borrowing from banks, as well as stock buybacks or paying back bank loans.
Cash flow is one of the big items that I dig into when recommending individual stocks. When you combine strong cash flow with solid sales and earnings growth, you have the beginnings of a solid company.
Now, it’s important to note that just because a company is bringing in cash, it doesn’t mean that it’s profitable—and vice versa—but as long as you have a good handle on all three of these aspects of a financial statement, you should be well on your way to understanding the nitty-gritty of a company.
The "Great Eight" Fundamental Variables
Growing companies are companies that are healthy and thriving. They have smart leaders who know how to run and manage a smart business. If a company is struggling to sell its products or is spending more than it makes, it’s not a company that you want to own for growth. And there are eight fundamental variables that are a significant part of my formula when evaluating a company come earnings season. Take a look:
#1 Earnings Growth: Earnings growth is the heart of all good financial analysis. Simply, "earnings" is just another word for "profits." This is a deceptively simple idea that is too often overlooked. The mainstream media is always finding excuses why a company didn’t post bigger profits—consumer spending was down, a key contract fell through, you name it! But I’m not in the business of making excuses. I’m in the business of finding companies that are posting bigger profits no matter what the rest of Wall Street is doing. As long as any company is vital and able to grow its earnings consistently, its stock will do well.
#2 Sales Growth: This is one of the hardest numbers to fake. Sales are the lifeblood of any business—whether it is selling a service, a gadget, raw materials or anything else under the sun. There are many ways that companies can temporarily find capital, such as selling off assets or making outside investments, but it’s always bad news if people aren’t buying what a business is selling. Great companies make sure that sales increase month to month and year to year so they can expand, dominate their industry and deliver big returns to shareholders.
#3 Earnings Surprises: One key metric I closely examine is whether or not a stock is consistently beating analysts’ estimates. Beating estimates is called an "Earnings Surprise." I measure these as a percentage, calculated as the difference between actual earnings and consensus estimates. I grade over 5,000 stocks on this key metric, and only stocks with the highest grades are worthy of my recommendation. If a stock beats Wall Street’s earnings forecast by a significant amount, share prices can rally dramatically. This is why I closely monitor the market to find stocks that regularly post earnings surprises. When I find an unsung stock that has regularly performed better than the "experts" have predicted, I recommend it on the premise that it should top expectations again—and see shares surge when it does.
#4 Earnings Momentum: While earnings growth is important, I also want to see a company’s rate of growth increase. This is what I refer to as Earnings Momentum. If a stock has shown that it is making more and more profits every quarter, it’s logical to think more of those profits will be returned to shareholders. But if a business is seeing earnings shrink or dip into the red, I do not consider it to be a good investment.
#5 Cash Flow: Simply, cash flow is the money a company has left over after paying for the costs of its business. This is a crucial indicator of success because brisk sales and revenue don’t always add up to big profits or an ability to expand. If every cent of a company’s cash is tied up paying bills, a big sales number has a limited impact. If a company is flush with capital and on top of its game, it will deliver shareholders big profits!
#6 Analysts Earnings Revisions: Upward revisions are an important indicator of a company’s future success. You see, analysts are paid to estimate a company’s earnings outlook. If an analyst makes a wrong estimate that ends up costing investors money, that analyst could be out of a job. If a number of Wall Street analysts start to move their forecasts higher, it’s a good bet that the stock will outperform expectations and deliver market-beating returns to investors since positive revisions are never made lightly.
#7 Operating Margin Growth: Making profits is all about the margin—the difference between production costs and the retail price. A company that’s able to expand its operating margins is usually a company that has a dominant position in its industry. This company can raise prices without seeing a drop-off in sales. That’s a nice place to be. But if a company has to keep cutting prices to entice reluctant buyers, it’s not a good sign.
#8 Return on Equity: This is one of my gold standards. In simple terms, Return on Equity is the amount of profits a company generates with the money shareholders have invested. ROE tells me how efficiently a company is managing its resources. I can’t interview every senior manager at a company, so I like to think of ROE as a report card for management. To check out a company’s Return on Equity, simply take a business’s net income and divide that by the amount of money shareholders own in common stock. If a company is run well, its net income will dramatically outpace what investors have pumped into it. If a company is lazy or poorly run, the value of shares investors own will be more than the profits the company actually produces.
These eight fundamental variables will help you get to the real facts that will make you money in all markets and at all times. The only way to profit in this market is to take a hard look at the numbers behind the stocks so you can invest in the biggest, strongest companies that will emerge from bear markets stronger than they were before.
But this isn’t all you need to know when it comes to earnings season—there’s plenty of other jargon that you should be familiar with. Let’s take a look.
Glossary of Earnings Season Terms
Analyst Expectations: This is one of the biggest market movers each and every earnings season—how a company performs versus analyst expectations. This won’t be in the official quarterly report from the company, but there are several places that take analyst predictions and average them together, including Bloomberg and Yahoo Finance.
A company can report a terrible quarter and institutional investors will cheer and bid up the stock, as long as it was a little less terrible than expected. Similarly, a company can report an exceptional quarter in real terms, but come in a few cents below expectations and be sold off sharply. Ultimately, this is a much bigger worry for short-term investors than it is for long-term investors, and sometimes provides exceptional buying or selling opportunities.
Earnings Surprise: Each quarter, Wall Street experts try to forecast a stock’s earnings per share. When they underestimate a stock, the company posts a positive "earnings surprise" that is calculated as a simple percentage. So if earnings for a given stock were forecast to be $0.10 a share and the company reports earnings of $0.12 a share, that is a 20% surprise—because $0.12 is 20% larger than $0.10. Positive earnings surprises show that a company exceeds expectations, and is doing better than investors predicted.
Earnings Disappointment: Similarly, if the company reported $0.08 a share on a forecast of $0.10 a share, it would be a negative surprise of 20%. A miss is more significant than a beat, considering that it’s often common for firms and analysts to lowball their estimates slightly so that everyone can be pleasantly surprised when results are better than expected. Not every miss means a company is in big trouble, but it does throw up a caution flag and requires a deeper dive into the reasons behind the miss.
P/E Ratio: The current stock price divided by last reported annual earnings per share.
P/E Ratio (Projected): Current stock price divided by the consensus analyst estimate of earnings per share for the next fiscal year (12-month) or the next two fiscal years (24-month).
Price-to-Sales Ratio: The current price of a stock divided by sales-per-share of the company in the most recent fiscal year.
Quarterly Earnings Change (%): The historical earnings change between the most recently reported earnings and the preceding quarter.
Quarterly Net Profit Margin (%): Net operating earnings after taxes for the latest quarter divided by revenues for the quarter.
Quick Ratio: A company’s cash and equivalents divided by current liabilities. This is an indication of a company’s financial strength.
Selling Into Strength: After good news such as a strong quarterly earnings report, even weak companies will see shares rise up briefly. Occasionally, I recommend "selling into strength" with our weaker stocks to maximize our returns by selling at the top of the bounce a company gets after earnings. Sometimes the difference in share price can be significant day-to-day.
Standardized Unanticipated Earnings: Relates the average earnings surprise at a company to the dispersion of analysts’ earnings estimates for the company and can be used to estimate the future likelihood of earnings surprises.
Whisper Number: At one point in time, this was the unofficial and unpublished earnings per share forecast that circulated among professionals on Wall Street and were generally reserved for specific high-value clients of a brokerage. As scrutiny on the brokerage industry has increased, it has been more difficult for whisper numbers to circulate, and the phrase is commonly used to refer to rumors of expected earnings surprises or misses.