How I Analyze Earnings Reports
Thursday, April 24, 2014

On Tuesday, I had a triple serving of earnings reports. Two of the stocks I follow for AAII Dividend Investing, Travelers (TRV) and AT&T (T), announced their quarterly results. Skyworks Solutions (SWKS), which I personally own, also released earnings. Compounding matters, the May issue of the AAII Journal was due to the printer. Needless to say, I had quite a bit on my plate.

Fortunately, I’ve learned techniques from years of analyzing earnings releases to streamline the process. It’s not a completely formulaic process since every company has different divisions and statistics. Some even release different documents. AT&T particularly bogs down the process by issuing a press release, two sets of presentation slides and several spreadsheets. Still, there are generalities of what to look for that apply to most companies.

Hone in on Revenue, Earnings per Share and Net Income—The very first thing to do is to determine the rate at which revenues, earnings per share (EPS) and net income have changed. Have they grown or decreased from the same period a year ago? How do the growth rates for each line item compare to the other two? If profits grew faster than sales, the company’s margins widened. If sales grew faster, margins shrank. If EPS grew faster than net income, then EPS was boosted by a reduction in the share count. Depending on how the earnings release is formatted, it can be easier to simply calculate the growth rates yourself.

Compare EPS to Expectations—In any given quarter, about two-thirds of companies tracked by analysts beat the consensus earnings estimate. A miss should be explained by the company. If it’s merely the timing of a key order or another temporary event, it may be justified to give the company a pass. If the company simply disappointed and you didn’t intend for the stock to be a contrarian play when you bought it, consider whether or not your sell rules are being violated. (Earnings estimates can be found on most financial websites, including Type in a ticker in the “Markets” section of the home page to call up a stock quote and then click on “Earnings” from the quote page menu.)

Examine Margins—A company’s executive team will do their best to put a positive spin on earnings, but profit margins may tell you a different story. Look to see whether gross margins (gross profits divided by revenues) and operating margins (operating profits divided by revenues) increased or decreased. Then look through the narrative of the press release to find out why margins changed. If margins narrowed, determine if it is the result of competitive pressures, a change in the product mix or some other factor such as higher raw material costs.

Calculate Free Cash Flow—Not all companies release their cash flow statement with their earnings, but many do. If so, calculate how much free cash a company generated. Don’t look at the EBITDA (earnings before interest, taxes, depreciation and amortization) figure, which some executives prefer you look at, but free cash flow. At AAII, we calculate free cash flow as cash flow from operating activities less capital expenditures and dividend payments. It should generally be positive unless the company had a big expenditure, such as a plant expansion, or the company has a seasonal business pattern.

Check Company-Specific Factors—There is no substitute for knowing the company you are analyzing, since key metrics will vary. I specifically looked for the number of postpaid (wireless customers under contract) additions in AT&T’s report. (They were good last quarter.) Since Travelers is an insurance company, I was interested in the combined ratio, which measures what percentage of premiums are paid out as a claims. (It worsened because of the winter storms, which wasn’t surprising.) I also scrutinized the numbers for the auto insurance segment, since this has been a weak spot for Travelers. (Still disappointing, but a new initiative, Quantum 2.0, was rolled out in many states.) The key here is to figure out what the key trends in a company’s business are and then look for the data and commentary in the press release that show how those trends are evolving.

Look Over Other Information—I will read through the earnings press release and scan through the conference call transcript. I’m looking for color on what is happening with the business and within the industry. If there is guidance, I will compare it to the guidance given in the previous quarter. Some companies may also announce dividends or changes to their stock buyback programs in conjunction with announcing their results.

Keep Notes
—Maintaining a log of a how a company is performing will help you identify trends as they evolve. These notes do not have to be formal, or even in complete sentences. They only have to be in a form you understand and can quickly refer back to. To give you a tangible example, here are the notes I wrote down for Skyworks Solutions:

Q214 Earnings: Adjusted EPS = $0.62, +29% from $0.48, consensus was $0.590, above guidance; GAAP net income = $76.9 mil, +24.6%; Revenue = $481.0 mil, +13%; Gross margins = 44.1% vs. 41.6%; Operating margins = 21.3% vs. 16.2%; Declared dividend of $0.11, ex-dividend date is May 9.

Q314 Guidance: Revenues +23% to $535 mil, non-GAAP EPS +35% to $0.73; current EPS consensus is $0.628; credits emerging markets (LTE smartphones), key programs, 802.11ac broadband deployment and more opportunities in the Internet of things.

I’ll admit that doing this type of analysis does require some time and effort, but less than you might think. I can often get through an earnings announcement in 15 to 20 minutes, including taking notes. By making the effort, I learn what is going on with the company and can better determine if the stock still matches my reasons for buying it.

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The Week Ahead

I will speak to our Portland chapter next Saturday, May 3, and our Puget Sound (Seattle) chapter on the following Wednesday, May 7. Not in the Northwest? Visit our local chapters page to find a meeting near you.

It will be another big week for earnings, with more than 140 members of the S&P 500 scheduled to report. Included in this group are Dow components Merck & Co. (MRK) on Tuesday, Exxon Mobil Corp. (XOM) on Thursday and Chevron Corp. (CVX) on Friday.

The National Association of Realtor’s March pending home sales index will be released on Monday. Tuesday will feature the Conference Board’s April consumer confidence survey and the February Case-Shiller Home Price Index. The first estimate of first-quarter GDP growth, the April ADP employment report and the April Chicago PMI will be released on Wednesday. Thursday will feature March personal income and spending, the April ISM manufacturing index, the April Purchasing Manager’s Index and March construction spending. April employment data—including the unemployment rate and the change in nonfarm payrolls—and March factory orders will be released on Friday.

The Federal Open Market Committee will hold a two-day meeting starting on Tuesday. The meeting statement will be released on Wednesday afternoon. No change in policy is expected, though traders and economists will be seeking more insight on the committee’s plans to eventually raise interest rates.

The Treasury Department will auction $15 billion of two-year floating rate notes on Tuesday.

The “worst” six-months for stocks will start on Tuesday. According to the Stock Trader’s Almanac, the Dow Jones industrial average has averaged gain of 0.3% from May through October since 1950. During the “best” six-month period of November through April, the Dow has averaged a gain of 7.6%. Don’t pull out of the market, but be aware that the historical odds suggest reducing your expectations over the short term.

Local Chapter Meetings

AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!

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AAII Sentiment Survey

Optimism among individual investors rebounded strongly, but still remains below average in the latest AAII Sentiment Survey. Neutral sentiment rose back above 39%, while pessimism fell below back below its historical average.

Bullish sentiment, expectations that stock prices will rise over the next six months, rebounded by 7.3 percentage points to 34.5%. This is the largest weekly change and the biggest increase in optimism since a 12.3 jump on February 13, 2014. Nonetheless, optimism is below its historical average of 39.0% for the sixth consecutive week.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 0.9 percentage points to 39.5%. This is a four-week high. It also the 16th consecutive week neutral sentiment is above its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, plunged 8.2 percentage points to 26.0%. This puts pessimism below its historical average of 30.5% for the first time in three weeks.

The current streak of below-average bullish sentiment readings is the longest since a six-week stretch between March 28 and May 2, 2013. Neutral sentiment is above its historical average for the longest consecutive period since a 24-week stretch between January 28, 1999 and July 8, 1999. Bearish sentiment has not been above average for three consecutive weeks since August 22 through September 5, 2013. This week's drop in pessimism ended a two-week stretch of above-average readings.

Neutral sentiment is back to an unusually high level, or more than one standard deviation above its historical average. Though the S&P 500 has bounced back and now sits close to its record high, uncertainty remains about whether a short-term market top has formed. Valuations are also playing a role and some individual investors may be waiting to see how first-quarter earnings look. Keeping some individual investors optimistic is the market's resilience, economic expansion, the Federal Reserve’s tapering of bond purchases and low interest rates. Keeping some individual investors pessimistic is the pace of revenue growth, the slow rate of economic expansion and Washington politics.

This week’s special question asked AAII members about their perception of the current state of the housing market. Responses were mixed, though 45% described the housing market as improving. About half of this group, or 21% of all respondents, said the recovery is slow or slowing. More than 7% of all respondents said the recovery is mixed with certain geographic areas or price segments doing better than others. Another approximate 7% described housing prices as being or getting expensive. Slightly less than 7% said the housing market was weak or weakening, while 6% described housing as stable.
Here is a sampling of the responses:

  • “Much improved, but a ways to go.”
  • “Housing prices are moving up and sales activity is increasing.”
  • “Slowly getting better, depending on the market location.”
  • “It’s bubbly in a few areas, but not nationally.”
  • “Sellers are inching up to prices they commanded years ago, but income has stagnated for many buyers. Not a great scenario.”

This week’s Sentiment Survey results:

Bullish: 34.5%, up 7.3 points
Neutral: 39.5%, up 0.9 points
Bearish: 26.0%, down 8.2 points

Historical averages:

Bullish: 39.0%
Neutral: 30.5%
Bearish: 30.5%

Take the Sentiment Survey.