Anyone who starts to read financial news will need a quick primer on the terms that are commonly used. To help you get a better understanding of what you read, we’ll briefly explore terms commonly encountered in market news—specifically, when a company announces its earnings—along with where you will see these words, what they mean, and their significance for the company.
- Company earnings announcements contain terms that any beginning investor needs to understand to know the health of the firm.
- Four terms commonly used in earnings announcements are net income, EBITDA, GAAP, and EPS.
- News reports also look at how much companies have in free cash flow, total debt, and assets they have available in cash equivalents.
- How effectively a company handles the cash it possesses and how it pays down its debts are both indicators of its ability to grow and increase shareholder value.
Example of an Earnings Announcement
To illustrate, here are excerpts from an apocryphal earnings news report covering a fictional company called Hemlock Incorporated:
Hemlock Incorporated announced its fiscal 2020 Q4 results after the markets closed, reporting non-GAAP earnings per share of 67 cents, an increase of 17% from the last quarter, coupled with a net income of $250 million, up from $235 million. Earnings guidance from Hemlock Incorporated fell within range, with EBITDA, net income from continuing operations, and free cash flow beyond the high-end of their respective guidance ranges.
Highlights from the fourth quarter of 2020 include:
- Cash and cash equivalents of $128 million
- EBITDA increase of 19% from Q3
- Free cash flow of $35 million, up from Q3’s $32.7 million
- Total debt increased from $95 million to $100 million.
However, despite the 17% EPS gain, Hemlock Incorporated fell well below the analyst earnings estimate of 71 cents. Coupled with Hemlock’s increasing total debt, some analysts are left questioning the company’s ability to service its debt moving forward.
Four Common Terms and What They Mean
This earnings announcement contains four terms that are commonly used. Knowing what they mean will help you understand what the announcement is really reporting.
1. Net income
At its most basic, net income defines a company’s total earnings or profit. Simply put, net income is what you get when you subtract all expenses (including tax expenses) from revenue. When a company’s net income increases, it’s normally a result of either revenue increasing or expenses being slashed. It goes without saying that an increase in net income is generally perceived as positive and factors into a stock’s performance.
EBITDA stands for earnings before interest, tax, depreciation, and amortization and is calculated by subtracting operating expenses from revenue and adding back depreciation and amortization to operating profit (aka EBIT). EBITDA can be used as a proxy for free cash flow (FCF) because it accounts for the non-cash expenses of depreciation and amortization.
On a company's income statement, EBITDA is a line item above net income that excludes other non-operating expenses, as well as interest expenses and taxes. It can be argued that compared to net income, EBITDA paints a rawer image of profitability. While some proponents of EBITDA claim that it’s a less-complicated look at a company’s financial health, many critics state that it oversimplifies earnings and can create misleading values and measurements of company profitability.
As a new investor, it’s important to know the distinctions between like measurements because the market allows firms to advertise their numbers in ways not otherwise regulated. Often companies will publicize their numbers using either GAAP or non-GAAP measures. GAAP, or generally accepted accounting principles, outlines rules and conventions for reporting financial information. It is a means to standardize financial statements and ensure consistency in reporting.
When a company publicizes its earnings and includes non-GAAP figures, it means it wants to provide investors with an arguably more accurate depiction of the company’s health, for instance by removing one-time items to smooth out earnings. However, the further a company deviates from GAAP standards, the more room is allocated for some creative accounting and manipulation (as in the case of EBITDA).
When looking at a company publishing non-GAAP numbers, new investors should be careful of these pro-forma statements, as they may differ greatly from what GAAP deems acceptable.
Finally, earnings per share (EPS)—one of the most common items highlighted in an earnings announcement—provides investors insight into a company’s earnings health, and often affects its stock price after an announcement. EPS is calculated by taking net income, subtracting the preferred dividends (for the sake of simplicity, let’s assume Hemlock Incorporated doesn't pay dividends on preferred shares), and dividing that difference by the average number of outstanding shares.
In the case of Hemlock, its current quarterly EPS is calculated by dividing its net income of $250 million by the company’s 37 million outstanding shares. When reported, EPS is typically compared to earnings from either the previous quarter or the same quarter in the previous fiscal year (year over year, or YOY). It is also used in basic valuation calculations like the P/E ratio (price-to-earnings ratio).
Cash on Hand, Money in the Bank
Another thing most news reports look at is how companies manage their money—specifically, how much they have in free cash flow, total debt, and assets they have available in cash equivalents, such as short-term government bonds that they can sell to settle debts.
In Hemlock’s announcement, free cash flow is increasing, meaning that after all expenses have been laid out in order to maintain the business’ continuing operations, the amount of cash it has on hand is growing. On Hemlock’s balance sheet, the company shows cash and cash equivalents of $128 million, which can be converted into cash if required, especially in the event that the firm's total debt increases and/or income takes a hit.
When assessing a company’s quarterly success or failure, pay attention to those terms. How effectively a company handles the cash it possesses and how it pays down its debts are both indicators of its ability to grow and increase shareholder value.
Plans and Expectations
Even though Hemlock has seen numbers jump in various areas over the past quarter, the fact that it missed analysts' estimates may not bode well for investor confidence. Earnings estimates are forecast expectations of earnings or revenue based on projections, models, and research into the company’s operations and most frequently published by financial analysts. Some companies will provide "guidance" of management's expectations for future results.
Even if a company sees an increase in profitability, if the actual earnings fall below expected earnings, the market will see to it that the stock price adjusts to the new information (read: drop in value.) This is due to the fact that estimates are usually built into the current price of a stock. When investors hear how a company “missed expectations” in spite of higher revenues being reported, the market corrects the price of the stock accordingly.
The Bottom Line
Like anything else in life, learning how financial markets work takes time. Adopting the easier approach by maintaining a level of ignorance can be dangerous, however, especially when it is the company’s prerogative to boost investor confidence by using as many positive values as possible. Knowing what each term means, why it is being used, and understanding how it affects stock price are just a few ways beginners can gain a better knowledge of the financial markets as well as critical-thinking skills when it comes to financial news.