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A
Closer Look at Earnings
More than half of investors polled earlier this year said they lack confidence in the
financial statements and earnings reports of corporations.1
Although this finding reveals that investor skepticism is at a high point, the
real lesson from the poll is the need to be extra vigilant when evaluating a
company’s financial information.
A company’s earnings still matter the most when considering stocks for your
portfolio.2 But deciphering financial
statements has always been a complex task — one that can require a trained
eye. Here are some examples of how earnings reports can be challenging to
interpret.
Buybacks and One-Time Gains
When a company buys back its own stock, the effect on earnings is usually
favorable. With fewer shares outstanding, the company’s reported earnings per
share would be expected to increase. However, it’s important to examine
whether the company’s decision to purchase its own stock was the best use for
its cash. Did it pay too high a price for the stock, or could the money have
been better spent on new technology or other corporate matters?
Nonrecurring gains also can boost earnings per share, but they may not
contribute to the long-term profitability of a company. Such one-time gains
might stem from the sale of assets or subsidiaries. Looking at the long-term
earnings trend may reveal a pattern of profits.
Turnover of Assets and Receivables
The rate at which a company purchases and depreciates assets can affect the
quality of earnings. Are large capital expenditures used quickly to efficiently
generate sales, or does the company take years to recover the cost? Does
equipment become obsolete before its value is exhausted?
If a company is slow to collect accounts receivable, the less efficient its use
of working capital and the greater its risk of bad debts. Quick turnover of
receivables can reduce the need to raise money from other sources that may
charge interest and cut into profits.
Cost Structure Differences
For companies with a fixed-cost structure, such as service organizations,
profitability may be limited until after business costs have been paid but then
multiply dramatically once that threshold has been crossed. For example, a 10%
sales increase may result in a 10% increase in earnings, but a 20% sales jump
may result in a 40% spike in profit.3 Companies
with a variable cost structure may experience other factors that can accelerate
or slow the effects of sales growth on earnings.
Even though the
information age has made company information more abundant, the most important
facts may be less apparent. There is no substitute for experience when it comes
to identifying companies that have strong earnings and the potential for growth.
1) The Wall Street
Journal/NBC News Poll, April 2002
2) The return and principal value of stocks fluctuate with changes in market
conditions. Shares, when sold, may be worth more or less than their original
cost.
3) This is a hypothetical example used for illustrative purposes only and does
not represent any specific investment. Actual results will vary.
©
2002 Emerald Publications
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