Long-term investors may be tempted to gloss over the minutiae, but the small print can often tell a company’s story. Learn some of the terms to know and why.
If you’re a long-term investor, it’s tempting to stay above the earnings fray. Quarterly reports from individual companies can sometimes confuse, and investors who become too focused on the fine print might get distracted from their overall retirement savings goals.
But that’s not license to ignore what companies say in their quarterly releases or conference calls beyond earnings and revenue. You should have at least a general sense of how major holdings in your portfolio are faring come earnings time, especially in cases where you hold individual shares. You might even want to check your mutual fund holdings, because some funds are heavily weighted toward a few big players, and it’s helpful to see what’s behind those companies’ performances.
So what are some key factors to look at?
It seems fair to state that every investor knows the ABCs of earnings, such as revenue, earnings per share, gross margin, and net income. But for those who may need to brush up, TD Ameritrade offers plenty of investment educational resources that can help anyone who needs to decipher those foundational aspects.
Long-term investors who want a little more insight into the companies they trade may want to wade more deeply into those earnings reports and other company filings, where they might come across some terms that can be key to determining a company’s health, including risk factors, competitive advantages, and cash flow.
Let’s examine them one at a time and explain why they’re important.
These are typically explained in a publicly traded company’s 10q or 10k filings to the Securities and Exchange Commission (SEC). Check the management discussion and analysis section of these filings.
“You may want to look at the management discussion and analysis section, because it’s not just numbers; they’re discussing risk factors and individual developments specific to the company, so you can get a better feel for what the company is exposed to in the economy,” said Shawn Cruz, a specialist in the Active Trader Group at TD Ameritrade. “If the company said it took a hit because of factor X, you can look and see whether it’s a one-time thing or a secular trend in which the market they serve is changing and the company might not be able to rebound.”
To get more insight, Cruz suggested listening to the earnings call. Analysts on these calls often ask company leaders about risk factors, giving investors a chance to hear straight from executives just how big a risk such factors pose and how the company intends to address them.
The management and discussion section of a company’s SEC filings, along with the earnings call, can also give investors a better sense of whether a specific firm has a so-called “economic moat.” Traditionally, a moat is a waterway surrounding a medieval castle that protects the fortress from invaders. Modern companies can also have these, though usually not in a physical sense, and the earnings call and SEC filings can help investors see and understand what they might be.
For instance, if the company in question is a large biotech, investors might want to listen to management discussion or read SEC filings about any major new or existing production plant the company uses. Biotech drugs are notoriously difficult to manufacture, so if it sounds like a company has a large and newer manufacturing footprint, that may be a sign that it has a leg up on the competition. Competitors may have great molecules in development, but be unable to manufacture them well enough to meet demand and satisfy government safety and effectiveness requirements. The first company has what analysts call a “high barrier to entry” that provides a competitive advantage.
The same can be true for other industries. Auto manufacturers, for instance. An up-and-comer may have a great concept, but will it have the capacity to make enough vehicles to meet demand? Listen to and read what the company says about its inner workings to find out.
Also, an existing company may have traditionally enjoyed a competitive advantage, but investors can check competitors’ filings and earnings calls to see if smaller competitors are catching up with the leader, possibly putting the leader’s stock at risk.
“Maybe something is changing and that barrier isn’t holding up,” Cruz said.
The last factor we’ll look at is a line item in the earnings report: Cash flow. This metric may not get the headlines, but it often can tell investors a broader story about a company and its prospects.
“A lot of investors are interested in everything else, but at the end of the day, how much cash is the company generating?” Cruz said. “Price to cash flow is a popular measure many investors use to compare one firm to another.”
If price to cash flow from operations is significantly lower at one company compared to another, it might be worth reading the other smaller print in the company’s earnings report to see what else is going on, because it could mean the market isn’t pricing in much growth. Perhaps there’s more than meets the eye, making the company’s stock price something of a bargain.
“If a company is generating a lot of cash, they may have more mobility in terms of what they can do with their business, including expanding or acquiring other companies,” Cruz said. “Free cash flow can be a big part of how to value an asset.”
TD Ameritrade offers resources to help investors learn more about reading earnings reports and how to decipher the fine print. Log on to TD Ameritrade, type a stock symbol into the search engine, and click the earnings tab for the stock. There, you’ll find access to the company’s SEC filings, analyst estimates, and recent earnings data.
All that is helpful, but to really delve in and learn more about what those data mean, consider enrolling in the Fundamental Analysis* course from TD Ameritrade's education affiliate, Investools from TD Ameritrade Holding Corp. This online course teaches you ways to evaluate the financial strength of a company by analyzing its financial statements. Investools also offers one-on-one coaching where you can talk to an instructor to deepen your knowledge about various trading strategies, and to become more disciplined with your investing plan.
A short video on Fundamental Analysis that gives some insight into reading a company's financial statement is also available to clients on the TD Ameritrade site and may help you decipher the small print.
TD Ameritrade, Inc. and Investools, Inc. are separate but affiliated firms.
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