Many investors think deciphering a company's quarterly earnings is like reading Homer in Greek, but interpreting earnings is easier than one might expect. The trick is to know what to look for and what to concentrate on. Knowing how to read an earnings report can provide a competitive edge in determining which stocks to buy or sell - and which ones to avoid altogether.
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What Is An Earnings Report?
As required by the Securities and Exchange Commission (SEC), public companies must issue quarterly earnings to provide an investor with an updated view of the company's financial status. Earnings consist of four major areas describing a company's financial health:
Obtaining the earnings report these days is easy. Most companies publish their earnings on their websites under "Investor Relations" and shareholders can usually have it sent automatically to them online.
In simplest terms, quarterly earnings provide investors with an updated scorecard of how a company is doing. It tells investors whether the company's sales and earnings are growing or declining. Here are the most important metrics to look for.
The best place to start is by reading the executive summary. In simple narrative form, a company explains its financial status and whether sales and profits are rising or dipping. For example, in Costco's (Nasdaq:COST) fourth quarter 2010 earnings, its net income increased from $374 million to $432 million year over year, and net margin rose from 17.1% to 18.3%. In a recessionary economy, this company seems to be prospering.
Sales can rise and yet profits can fall. If a company's expenses and costs are spiking faster than revenue, its profits can falter. If the revenue spurt is attributable to sales of one hot product, like a toy company with a holiday item that is flying off the shelves, investors may be wary because the odds of duplicating the success the following year aren't strong. When reading earnings, investors must ascertain what's driving the revenue and then determine whether this growth can be sustained.
Assets vs. Debts
Assessing a company's financial status is like analyzing someone's net worth. In the balance sheet, companies disclose the assets the own and debts they owe. If a company has $2 million in assets but has $4 million in debts, then the company has a lot of debt relative to their assets, resulting in what analysts call a high debt-to-equity ratio. Investors often view high debt-to-equity ratios unfavorably.
Earnings Per Share (EPS)
This metric is usually found in the income statement, which indicates a company's profits allocated to each outstanding share. For example, for its fourth quarter 2010 earnings, Monsanto's (NYSE:MON) EPS rose from a loss of 43 cents in 2009 to a smaller loss of 26 cents in the recent quarter, so profits seemed to be recovering.
Those earnings per share lead to its price to earnings ratio (P/E), which is its price per share divided by earnings per share. If a company was trading at $42 a share and earnings over the last 12 months were $2 per share, the P/E ratio would be 21. The P/E is usually used to compare with industry peers or as a benchmark to gauge whether the company is relatively undervalued or overvalued.
If the company issues a warning and says they expect sales to decline 10%, the company is in for a rocky road ahead. On the other hand, if it forecasts increased sales, it bodes well for the company.
Quarterly earnings can also tell an investor that the original reason for buying the stock is no longer applicable. If an investor purchased Starbucks (Nasdaq:SBUX) as a growth stock and the coffee chain starts closing stores globally, then he or she will need to reevaluate the stock.
The Bottom Line
In essence, quarterly earnings function as a company's report card, revealing how the company is doing, whether management is doing its job effectively and whether it's on a road to rising or decreasing profit in the future. After identifying these numbers, investors must interpret and analyze them to reach their own conclusions. (For related reading, take a look at What You Need To Know About Financial Statements.)
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