Fundamentals: Tricks In Looking At Company Earnings

Poring over financials can be a boring task, but serious investors can get ahead of the market by checking out significant data in the financial reports that managements issue each quarter. Many professionals overlook the early warning signs that are revealed in corporate shareholder reports.

Read the Letter To Stockholder and compare what management is saying now with what it said last year. Was it correct in its projections/forecasts for business prospects? Is it honest about negative developments? This allows you to test the integrity of the management.

Also ask if you can get a copy of the annual and quarterly returns of the company to the SEC and compare it with the information that’s published to stockholders. This is a perfect test to see if the company is holding information from the stockholders which it would otherwise be unable to withold from the SEC. It will also be evident if the company is window dressing its operations for the stockholders.

Have a look at the item called Deferred Taxes on the company’s year-end financial sheet. Companies that are aggressive in accounting practices have greater differences between its shareholder books (its regular profit and loss statement) and the way it reports income to the government. Companies can legally report income and expenses differently to the public and to the tax authorities. For example: Capital purchases can be depreciated more slowly in the shareholder’s report (enhancing earnings) than in the report to the government (where accelerated depreciation decreases earnings and taxes). The difference is captured in Deferred Taxes.

Rely more on the earnings reports and the projections made by managements that are conservative in their accounting.

Tax rates are important to look at, too. Here the important thing to observe is a change in the tax rate from year to year. If the company’s tax rate (usually in the P&L) goes down suddenly in the fourth quarter, earnings for the quarter may appear very good. An investor probably can’t count on that boost in earnings turning up again. This can mean that future earnings may be disappointing, and the market may be caught with another earnings “surprise” on the downside.

The signs are often not what they seem. A big drop in the cost of goods sold, general and administrative expenses, or research and development as a percent of overall revenues may not be all good news either. The decline may be nonrecurring. Then what does the company do for an encore in comparative reporting?

Sharp investors keep a keen eye on inventory figures. If inventories are rising faster than sales–especially for a retailer–there’s trouble ahead. Get out of any stock where the inventory turnover is steadily declining (i.e. cost of goods sold / average inventory). Declining retailer inventory turnover in as many cases are caused by a buildup of slow-moving goods that should have been pushed out the door rather than kept in inventory.

Another trick very rarely used by most people: A big increase in finished goods in inventory, but work-in-process inventories that don’t go up nearly as much, and raw materials inventories that actually drop. What that means: Management is bearish regarding its near-term prospects, and so has slowed down buying raw materials. The reverse, of course, is positive: A bigger increase in raw materials inventories than in finished goods means that management is filling the production pipeline because incoming orders are excellent. (Be careful that the increase isn’t due to some major price increase in raw materials for the industry.)

The fundamentals to check in every earnings report:

• A bulge in accounts payable. The company may be short of cash and stretching out bill payments. Watch out!
• Short-term debt. Look carefully at this because many companies are covering up short-term liabilities (such as commercial paper) and calling it longer-term debt since it’s covered by a bank’s line of credit. Short-term debt is a burden on a company, making it vulnerable to interest rate increases. Also, the company’s bankers may force the company to amend loan covenants, curtailing the operating flexibility of the company in a way that can be detrimental to the long-term interest of all the present shareholders.
• Dividend payout. Too many managements are unwilling to cut dividends during tough strikes or other sharp reverses. When a company’s resources are drained to pay a dividend, start worrying about the quality of management. It takes tough managers to cut a dividend. And, in the long run, tough managers are good for the company. On the other hand, when business is doing well, it takes astute managers to reward shareholders for it by issuing an appropriate dividend. The ability to balance business with shareholder interests is a hallmark of good management.

One of the most bullish signs in an earnings report is a big bath–a big writeoff, often associated with a long overdue restructuring of operations, including the sale of losing or low-margined businesses. Chances are good, with a big bath, for a real turnaround in earnings. The market may be disappointed at first, but it usually reads a big bath positively and increases the P/E multiple of the stock.

Source: Big Black Book.