In many ways, we’ve become a society that is obsessed with numbers and analytics. It’s interesting, therefore, that many individual investors will spend a great deal of time poring over next-generation statistics to choose a tight end for their fantasy football team, but just a scant few minutes looking at a company's earnings report.
One reason for that is that an earnings report is an intimidating document, and unless you are a financial professional, it’s probably going to be a little boring. That is unless you know what to look for. Because as an analytics society, an earnings report is about as pure as it gets. An earnings report contains valuable information that can go a long way to helping an investor decide whether or not they should invest, or continue to invest, in a company. And what should be most important to investors is that the data in an earnings report is required, by SEC regulations, to be accurate.
But it’s still a document with a lot of numbers and legal-ese that requires translation, and that’s why we’ve created this article. We’ll go over what an earnings report is and how investors can cut to the chase to get the information they want. We’ll also go over why earnings reports are important, why you can rely on them for accurate data and the quantitative metrics that can help your fundamental analysis.
What are earnings reports?
Earnings reports are part of the legal requirements that publicly held companies must meet to disclose their company’s performance. These are typically issued quarterly and are part of what investors call the “earnings season”. These reports are a subset of a company’s 10-Q filing and contain items such as net income, earnings per share (EPS), earnings from continuing operations, and net revenue/sales. You will usually hear things about how the company performed relative to their top line and bottom line numbers. These numbers can be found directly in their earnings report.
Top line refers to a company's net revenue/sales. The bottom line refers to their net income. These are two metrics that are used in the fundamental analysis of a company's stock. Ideally, companies will be showing growth in both their top and bottom line numbers, but sometimes they will be showing top-line growth that is not reflected in their bottom line or vice versa. Sometimes this is explained by market conditions and sometimes it is indicative of a bigger problem affecting the company.
It is also important to understand that an earnings report is not the same as a company’s 10-Q document. Form 10-Q is a “just the facts” document that is required by the SEC and contains detailed financial information that the company must provide. Because the 10-Q is also a public document, companies will only provide abbreviated information from the 10-Q in their earnings report.
What are the components of an earnings report?
While earnings reports do not have to be identical, they do follow a general structure. The first part of the report contains the company’s financial information in a condensed format. As mentioned above, this won't give investors all the information that's found in the 10-Q document but will provide them with enough information to get a sense of the company's performance. After displaying the raw data, there will typically be a section where the company provides a commentary on the data. Some questions that you may want to consider are as follows:
- Was the company’s performance better, worse or the same as the previous quarter?
- How did the company’s performance in this quarter compare with their performance in the same quarter the prior year? This is a particularly good question for “seasonal” stocks like retailers who rely on the fourth quarter for much of their revenue.
- Compare the cost of sales between quarters. Is it costing the company more to bring in revenue?
- What is the company's cash flow? If the company has a negative cash flow but is still showing a positive net income you should be looking for an explanation as to why this is happening, particularly if it is a mature company.
The second component of an earnings report (sometimes called “other information”) goes through some of the potential issues that a company may be facing. This can be hard to read because it has undoubtedly been vetted by a company’s legal team so the wording is very precise. The important thing to consider when looking at this information is are the risks facing the company, either from lawsuits or general market conditions, specific to this company or are other companies within the sector experiencing the same issues. If so, is this company in a better, or worse, position to manage that risk?
Why do earnings reports matter?
Simply put, earnings reports move the market. During “earnings season” analysts and institutional investors rely on the information contained in the earnings report to make projections for the following quarter or year. Analysts form their own estimates independent of a company’s estimates. So when the earnings reports are released, analysts are looking to see not just whether a company beat their own estimates, but whether they beat analysts’ expectations. Most companies take an under promise and over deliver approach to future earnings. However, many analysts may see this as a way of a company being too conservative with their estimates so as not to disappoint. In these cases, you may hear of a company that met its forecast but came in short of where analysts expected.
In other cases, a company may try to project much better forward earnings than what analysts feel is warranted. In this case, you may see a situation where a company misses on their estimates but still come in higher than what analysts expected.
While this may seem like an imperfect way to determine the direction of a stock’s price movement, the ability of a company to meet analysts’ expectations is a key driver of stock prices both positively and negatively.
Are earnings reports accurate?
No company will lie in their earnings reports. That’s because the information in the earnings report must match the company’s Form 10-Q which is a legal document that a company must file with the Securities & Exchange Commission. So every number in the earnings report must match what’s in the 10-Q. The earnings report, however, does give companies the opportunity to comment on the numbers. In the case of numbers that were below what the company forecasted, they will offer an explanation for the miss.
The earnings reports role in fundamental analysis
When you purchase shares of a company’s stock, you are buying a piece of that company. Fundamental analysis considers both quantitative and qualitative factors in determining whether or not a company belongs in your portfolio. An earnings report will not typically deliver on the qualitative factors. However, because it is so data intensive it can go a long way to helping you understand important quantitative metrics including:
- Earnings – This is the company’s bottom line. How much did they earn after taxes and dividend payments? You’ll also want to look at their “earnings per share” number. This is the earnings number divided by the average number of outstanding shares.
- Price-earnings (P/E) ratio – This is the price of one share divided by the earnings per share. The P/E ratio tells you how much money investors are willing to pay for each dollar of a company’s earnings. By itself, the P/E may not mean that much, but you can compare the company’s P/E ratio to competitors in their industry to see if their shares are trading at a premium or a discount.
- Dividend yields (if applicable) – Many large companies offer dividends as a means of increasing shareholder value. The dividend yield is the company’s dividend expressed as a percentage of the share price. Therefore, a stock that sells for $50 and pays $3 a year in dividends has a yield of 6%. Ideally, you are looking for a company that combines dividends that are increasing with earnings that are also increasing.
- Book value – This measures the difference between a company’s assets and its liabilities. As an investor, you may be particularly interested in the book value per share. This is arrived at by dividing the company’s book value by its number of outstanding shares. A positive sign is a stock that is selling at a price no higher than 1.3 times book value per share.
- Return on equity – this is usually reported directly in the earnings report. What this tells you is what a company’s net profit is after taxes divided by its book value. A return on equity of 15% or higher usually indicates a well-managed company.
- Debt-equity ratio – Simply put, how much debt a company has on their books compared to the equity they are generating from shareholders. This is a metric that should be taken with a grain (or two) of salt because some startup companies need to take on debt in their initial stages to achieve growth, particularly if they are not ready for an initial public offering (IPO). If a company has $1 billion in equity and $250 million in debt, its debt-equity ratio is .25 or 25 percent.
- Beta – This measures a stock’s volatility relative to the S&P 500 stock index which has a beta of 1.0. A beta above 1.0 means that it rises or falls by a percentage more than the index. A beta below 1.0 means that it rises or falls at a percentage that is lower than the index.
The bottom line on earnings reports
As we’ve become more sophisticated consumers, we are less impressed by marketing “spin” and instead look to data for answers to questions. If it can be measured, we try to measure it. However in many cases, data has become its own marketing tool and there are so many numbers, that we get inundated with data without a clear understanding of what the data is really telling us, and in some cases inserting our own bias to make the data say what we want it to say.
That's why an earnings report is so valuable for investors. While the information contained in them may not be bedtime reading, an investor can rely on an earnings report for accurate, no-frills information that can help them make wise investment choices. Furthermore, a basic truth about earnings reports is that they move markets. Analysts have expectations and when those expectations are met, the stock generally rises. However, when they're not met, the stock generally falls. As an individual investor, it's your responsibility to decide whether the price movement is justified.
The earnings report is usually a precursor to a company's conference call (or earnings call). Both in the earnings report and the conference call, a company's upper management will highlight quarterly successes and/or provide reassurance for areas where the company may have underperformed.
Finally, while the earnings report is one of the major pieces of data you can review; it is just one piece of data. The market does not always behave in logical ways and often times, bad things happen to otherwise good companies. Whether you are already a shareholder or considering investing in a company, you are looking to become a part owner of that company and the earnings report is your prospectus.