Feeling flustered as earnings data hit the screen day after day? Though the numbers can appear overwhelming, there are simple ways to interpret a company’s quarterly report without combing through page after page of tiny numbers and befuddling footnotes.
All that fine print can confuse investors, leaving them unclear of a company’s overall condition. After that, the temptation is to simply focus on the big number: Earnings per share. But that metric has issues of its own.
Focus on Revenue, Not Earnings Per Share
Investors should focus on revenue and be wary of putting too much faith in the earnings per share number, says Sam Stovall, Managing Director, U.S. Equity Strategist, S&P Global Market Intelligence. Companies can “fudge” on earnings per share by making various adjustments. “But it’s hard to get around reporting actual sales or revenues,” Stovall says.
Earnings per share isn’t as clear a number as revenue. A company can buy back shares, artificially inflating its EPS, for example. And there are various different types of EPS, including adjusted and generally accepted accounting principles (GAAP), which can throw some investors off. Getting a solid understanding may require time with a company’s Securities and Exchange Commission (SEC) filings.
Revenue, on the other hand, is easy to track and gives an unfiltered view into exactly how the company’s products are doing. Although outside factors such as foreign currency effects and product pricing can play into the revenue figure, for the most part it’s unvarnished and transparent.
Two Other Key Metrics Besides Revenue
Beyond revenue, investors can learn a lot about a company by checking its quarterly cash flow and dividend ratio.
“Make sure you look at cash flow, because cash flow is the ability for a company to pay its bills,” Stovall says. “Some people are asset rich but cash poor, and you don’t want to be cash poor because you might be forced to liquidate assets below market value price. The same is true for companies. So for companies, cash flow per share is a very important metric. Not only is it the ability for a company to pay its bills, but also to pay its shareholders.”
Cash flow is the net amount of cash and cash equivalents moving into and out of a business. A negative cash flow isn’t necessarily bad, because it may reflect investment back into the business. A company can have a negative quarterly cash flow and still be considered cash healthy if reserves remain high. As with revenue, cash flow is hard for companies to manipulate in an earnings report. Some analysts think it’s the best way to judge the true financial heath of a company.
The other earnings benchmark, Stovall says, is dividend coverage ratio or payout ratio. This data tells investors what kind of cushion there is between EPS, cash flow per share and dividends per share.
For instance, if a company’s dividend per share is $1.50 but EPS is $2.50, that’s a whole dollar for cushion. In this case, the payout ratio is 60%.
“You don’t want to go much above 70% to 75% payout ratio,” Stovall says. “If a company falls briefly on hard times, it might have to slash or omit its dividend. So if you look at payout ratio and it’s substantially below earnings, it means the company still has a cushion.”
Let Your Fingers Do the Walking
Though it may sound a bit old fashioned, picking up the phone can be one of the best ways to understand a company’s earnings report.
“One other thing to focus on and often the most helpful is to listen to the earnings conference call,” said JJ Kinahan, Chief Market Strategist at TD Ameritrade. “This can help you make sense of current numbers and the goals that the management team is laying out for the company. This can certainly help you shape your future investment ideas.”
Missed the call? Not a problem. Most companies post call transcripts on their investor relations web sites within a day or two of earnings. Sometimes, reading the transcript makes things even clearer than listening to the call itself, as investors can take things at their own pace and scroll through to find particular areas of interest.
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