Earnings season is a bit like the casino game craps. You can win or lose a lot of money. Fast!
As we prepare for earnings season I wanted to offer a few tips to help guide you through the next few weeks. Because as companies report their quarterly results, it can lead to a wild ride for stock prices!
First, ignore the headlines.
Websites such as Yahoo! will post articles that proclaim XYZ Company beat earnings expectations by $0.03 a share. And, believe it or not, investors react to that news without doing anymore work. They forget that it’s important to actually read the press release and determine whether the sources of earnings are sustainable.
Second, find out if the revenue that companies report is of good quality.
One thing you can check is their balance sheet: Does the growth in revenue compare with the growth in receivables? If receivables are way up, it could indicate management offered customers incentives to purchase a product today that they otherwise would’ve bought at a later date. Great now, but what about future earnings?
Third, look at profit margins and determine if the changes make sense.
Expanding margins are not a good thing if management is using accounting shenanigans to overstate the results. For example, a company may write off inventory in one period, and sell it in the next for a 100% profit margin boost!
Fourth, analyze the tax rate and share count.
Companies can use a variety of tax management strategies to get their tax rate down, effectively buying a penny per share of earnings. Stock buybacks do the same. So sometimes companies appear to beat earnings when they’re really just rounding up the reported earnings per share.
Fifth, track inventory growth on the balance sheet.
If inventory is rising and demand is starting to slow, for any reason, future margins are at risk. Unless inventory is rising ahead of a product launch or based on demand, watch out for it.
Sixth, check the cash flow.
For all a company might earn, it can’t spend earnings. It can only spend cash. Most companies do not report their cash flow numbers in the earnings release. That means it’s important to check them in the SEC filing, which usually comes out within 45 days after the quarter. (Remember, cash is king.)
These are a few quick things you can do to check up on your holdings so you can spot trouble before the stock implodes and torpedoes your portfolio. Many of the warning signs are right there in plain sight. Don’t be the kind of investor that ignores them.
John Del Vecchio