Earnings reports are trickling out from some of the biggest public companies, and investors remain uncertain about the current environment. Economic expansion is slowing and sentiment is muted, but good earnings data could boost stocks into the next leg of the bull market. Are you up to speed on how to read earnings reports? If not, this article will provide the knowledge to decipher earnings data and separate actionable info from corporate fluff, making you a more confident investor.
Why do public companies release earnings reports? For starters, it's the law - the Securities and Exchange Commission (SEC) requires public companies to make regular financial reports to shareholders.
Additionally, earnings releases are like report cards for public companies. Investors learn how much money the company is making, how it is spending its cash and what executives see in the firm's future. Earnings reports are often market-moving events, so investors should understand how to read and interpret the data in these releases.
Step 1: Understand the Key Components of an Earnings Report
When companies report quarterly earnings, investors look for results and potential. Did the company over or underperform expectations for the quarter? What’s the outlook for the next quarter or year? Here's what to pay attention to when reviewing company earnings results.
Revenue and Profit
American economist Milton Friedman famously said, “The business of business is business.” Meaning that a public company is judged based on its ability to make money. However, measuring the money a company makes can be a detailed endeavor. Analysts often refer to "top line" and "bottom line" numbers regarding earnings. The top line is revenue, which means the total gross sales for the quarter. The bottom line is profit, which is how much revenue is left after subtracting expenses.
Companies measure profit in three ways:
- Gross Profit: Often referred to as cost of goods sold (COGS) or cost of revenue, gross profit subtracts costs associated with production from revenue.
- Operating Profit: Operating profit is calculated by subtracting the company's costs (payroll, rent, etc.) from gross profit.
- Net Profit: To find net profit, subtract interest and taxes from operating profit.
Earnings Per Share
Earnings Per Share (EPS) is how much net profit a company makes for each outstanding share of stock. To find EPS, divide the company’s net profit by the outstanding shares. For example, if a company reported net earnings of $100 million and had 25 million outstanding shares, the EPS would be $4.00.
Additionally, there are two ways to measure EPS: basic EPS and diluted EPS. Basic EPS tallies all current shares, while diluted EPS factors in securities like convertible bonds that may become shares in the future.
Investors can use EPS to compare companies in the same industry. If Company A earns $4 per share, but Company B earns $5 in the same field, Company B might deserve a closer look.
Like a blockbuster movie, the most pivotal part of an earnings report often unfolds at the end. Known as "guidance" in analyst terms, this is where company executives share their outlook for the next quarter or the rest of the year. During the company’s conference call, executives go into detail about the reported numbers, providing context and updating expectations for the future.
Future expectations are often the most actionable part of the earnings report, as poor forward guidance can sink a stock even if revenue and earnings beat analysts’ estimates. When listening to a conference call, pay close attention to guidance or any forward-looking statements since future earnings dictate the path of stock prices.
Step 2: Analyze and Evaluate Data in the Earnings Report
Now that you know how to read an earnings report, how do you turn that information into an actionable investment plan? First, compare the results to past releases and then use the data to take the company’s proverbial temperature.
A single earnings report doesn’t necessarily tell an investor much. However, comparing present data to past results can clue investors in on whether the company will be able to meet its stated goals. For example, if revenue growth is slowing and margins aren’t increasing, it could be a sign of trouble ahead.
Assess Financial Health
How do earnings numbers figure into the bigger picture? Expanding revenue growth is great, but what if that revenue comes at an increasing cost? In that scenario, it might be wise to look at the company's cash flow and debt level to see if it can absorb rising costs. An earnings report is like a thermometer — it can tell you something is wrong but won’t provide an acute diagnosis.
Step 3: Avoid Common Mistakes to Improve Your Interpretation
Like any financial indicator, earnings reports must be used in the proper context to be effective. Here are a couple of mistakes to avoid when incorporating earnings data into your research.
Overemphasizing Earnings
Some investors place too much weight on a company meeting short-term goals and not enough on the long-term progress of the business. An earnings report is a snapshot of a company at a specific moment in time. One-time or non-recurring events can influence these numbers, so it is important not to use a single quarterly earnings report as your basis for due diligence.
Ignoring Industry and Economic Context
A stock in your portfolio beat analysts’ estimates? Great, but that doesn’t mean it's the top company in its field or even headed in the right direction. Earnings should always be used with the industry backdrop in mind. Is this particular company growing faster than other industry cohorts? Are the revenue boosts due to expanding market share or overall economic improvement? Use these data points to examine whether a company is outperforming (or lagging) its peers.
Practical Tips for Beginners
You don’t need a finance degree to understand financial reports, but you must learn the vocabulary and how to contextualize different information. Follow these suggestions to get the most out of company earnings data.
Simplify Financial Jargon
Financial reports are usually dry and loaded with technical terminology. Company executives aren’t trying to entertain but to report numbers with clarity and precision. To interpret earnings reports and conference calls, you’ll need to have a basic understanding of the language of business. MarketBeat has an encyclopedia of financial terms to help you memorize the meanings of revenue, earnings per share, profit margins, net income and more.
Look for Visual Aids
Looking at walls of text or numbers can make even the most seasoned investor’s mind wander. One tool that MarketBeat users can leverage in earnings analysis is charts showing analyst estimates or EPS growth over time. Tables and charts, as visual references, help us better understand trends and make company comparisons easier to grasp.
Join an Earnings Call
Earnings calls aren’t secret meetings between executives and analysts. Anyone with WiFi can tune into a company’s earnings call and listen to the commentary firsthand. You won’t get to ask a question, but you can hear the figures and guidance directly from the source and form your own opinions. These calls generally happen during pre or post-market hours, and recordings and transcripts can be found on the company’s investor relations webpage.
Seek Expert Advice
If complex company data is too complicated for you to interpret, analysts and market observers offer ample commentary on earnings reports. How does your opinion stack up against the experts covering the company? MarketBeat has tools that track not only earnings releases and headlines but also the opinions of analysts covering the reporting companies. Leverage expert views and due diligence to make the best investment decisions.
A Useful Snapshot, but Not the Full Picture
Earnings reports are helpful (and mandatory) releases of company data to investors and the public. These documents report key figures like revenue, margins and income, and conference calls can provide insight into the company’s future plans and goals. However, remember that earnings reports are only three months of data and must be evaluated in the context of the company's overall financial health to be beneficial.
Earnings season is starting to heat up, with many large-cap companies set to report in the coming weeks. Be sure to stay on top of these releases with MarketBeat’s products and tools.
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