A guide to earnings analysis

EARNINGS growth is one of the most important determinants of stock prices. And knowing how to look at earnings correctly is a must for investors.

Below are some guidelines to help you:

An earnings report tells the general economic health of a company. It includes the amount of money a company made during a specific period such as annually or quarterly. It can help you determine whether to buy, sell, or hold a stock. To understand the numbers and its context more deeply you can join a company’s earnings call or even read its meeting transcript.

There are a few ways a company could increase its earnings. It can improve or shut down losing segments, cut costs, raise prices, enter new markets or sell more products in the old markets. Take note of where the earnings growth is coming from. Some of it would have shorter effects and some would bring longer term growth momentum.

Be wary of earnings headlines or press releases that hide the essence of the results. Press releases and presentations of an earnings report may show positive bias so doing your own due diligence is a must.

You might see headlines that say sales is up 20 percent, but net income is flat. Read the quarterly earnings report. Browse through it and see if you spot any inconsistencies.

Look at the earnings per share or EPS growth not just the earnings growth. Let’s say a company had P1 million capital with a million shares and made P100,000. It then doubled its capital issuing an additional 1 million shares increasing it to P2 million and making P150,000. If you simply compare the net income, it will show that the company increased its earnings by 50 percent. However, EPS actually declined 25 percent from P0.10 to P0.075.

Focus on recurring earnings. Sometimes a company’s profits might have jumped from one time events such as a sale of an asset that suddenly produces extraordinary gains. Since the gain is nonrecurring you should remove it from the net income to gain a better picture of the company’s regular earnings.

Search for consistent revenue and earnings growth. A growth in sales only but with a reduced earnings growth might mean the company cannot pass along costs to its customers. A growth in earnings without any growth in sales might mean earnings growth is temporary and is due to cost cutting measures rather than real product demand.

Use other financial statements such as the balance sheet and the cash flow statement to verify the sustainability and consistency of earnings growth. For the balance sheet, check if the company has a sound balance sheet with manageable debt levels. Accounts receivables and inventory levels should also grow preferably at the similar rate as sales. For the cash flow statement, a positive operating cash flow could indicate healthy growth and less operating capital needs.

Some items in the financial statements will greatly affect earnings unrelated to the company’s operations. Given the same operating earnings a company with a larger interestbearing debt will produce a lower income. An example is the interest expenses of a company. It is a nonoperating expense and will increase if the company incurs more debt or if interest rates rise.

If you want higher earnings momentum look at the annual and current quarterly earnings. Look for accelerating earnings or a continuous earnings uptrend. According to Willian O’Neil, a standout stock needs to show not only a sound earnings growth record during the recent years but also its last few quarters. He suggests looking for stable and consistent five years’ earnings. He also prefers that the annual compounded growth rate of earnings should be from 15 percent to 50 percent or higher while having two quarters of major earnings deceleration could mean trouble for the company and might indicate slowing growth.

Expectations versus reality. Analysts and brokerage houses have quarterly earnings estimates. Some companies also give their own guidance. Any difference between the actual earnings, especially a huge one could warrant a rating downgrade or an upgrade and could affect stock prices significantly.

Learn to look beyond the current numbers. It is also important to look at other factors such as changing financial and industry environment, government regulations, and technological changes that might impact the earnings of the company going forward. Taking these into account should reduce the risk of focusing only on the current and allows one to be able to think into the future.

As Peter Lynch has said: “If you can follow only one bit of data, follow the earnings — assuming the company in question has earnings... I subscribe to the crusty notion that sooner or later earnings make or break an investment in equities. What the stock price does today, tomorrow or next week is only a distraction.”