Understanding Corporate Earnings

I am assuming most of us have listened to the financial news at least once and heard about how our favorite companies met or missed their earnings targets, and the big effect this announcement has had on the company's stock price. You and I must agree that there sure is a lot of hype around earnings.  But is this figure really a good measure of profitability? Unfortunately, at least in my opinion, the answer is no if earnings are just taken at face value.  Earnings reported to us and focused on by Wall Street are not really what matter most for the long term profitability of a company, and focusing on this as the core of your investment decision will probably not be very profitable for the long term investor.

What do I mean with this outlandish statement? Unfortunately, companies often use creative accounting measures to make their earnings look better than they really are.  And unless you're able to pick through the income statement and balance sheet to look for these, the earnings number doesn't have a lot of importance.

So what is an investor without a CFA (Chartered Financial Analyst certification) supposed to do? I mean, aren't the income statements and balance sheets supposed to tell me about the company and help me make my investment decision? Well, yes they should, but you still have to do your due diligence. Many of these accounting measures aren't technically illegal unless they become a habit for the company.  However, as investors have found out, just because it isn't illegal doesn't mean it can't come back to bite you. After all why would you invest in a company if you knew they had relaxed their credit policies so they could report higher revenues? This while knowing that a lot more accounts would go unpaid or that they shipped inventory "by mistake" so they could book sales they knew would be returned later? Of course none of us would.

So now let's look at some examples of what companies do to make things look better than they are and how you can avoid them.

"If your supplier says no, our company says yes"

Remember those old commercials, "if your bank says no we say yes"? Why do you think they did that? It was because they wanted customers to lend to bad enough that they were willing to take people that other banks wouldn't touch. This of course in the end meant that they would have more people not paying their loans and a lot of times they wouldn't get paid. This is okay as long as it is company policy and properly accounted for. However, when a company makes a more sudden switch in their credit policy to make higher revenues that they wouldn't necessarily get otherwise, the company could be in trouble. This could result in a write down next quarter or lowered earnings in the future. This is the typical short-term thinking companies sometimes have when they want to satisfy their goals this quarter and worry about things later. Unfortunately, though, later comes a lot sooner then a lot of us would like.

Luckily there is a way to help you avoid this by looking at revenues in relation to sales. First look at sales over the past 5 or 10 years (I would use 10). Look at how much revenue has grown in each year for that time frame. Now go to the balance sheet and do the same for accounts receivable. If accounts receivables are growing at a much higher rate than sales then you might want to avoid the stock. You can also divide accounts receivable by sales to see what percentage of sales is financed by accounts receivable. If this is a large number and growing, watch out.

Complicated Annual Report or Accounting Info

Accrual accounting gives a company a lot of space to play around with the numbers. However this reporting isn't always necessarily clear to the average investor because companies use their annual reports as a way to sort of hype up the company.  Or they might even use complicated ways of explaining things in order to hide the fact that they aren't doing very well.

Companies have to be a little bit more objective in the 10-K and 10-Q reports, which you can look up for free.  But if you don't have much of a background in accounting or finance, the best way to avoid this problem is just to avoid companies who are involved in activities that make no sense to you. However since most companies will have at least one business segment that you might not understand, the best way to decide if you want to invest in them is to calculate what percentage of revenues come from these activities you don't understand. If most of the revenues come from something vaguely described or you don't understand you should probably look elsewhere. For example consider Mirant which was in the same business as Enron and reported 221 million of risk-related activities which were never explained. This accounted for most of the revenue for that particular period and should have been a warning sign to all investors who didn't get out before it declared bankruptcy. Of course we now know that risk-related activities are not a good place to have our money.

Growing Inventory Exceeds Sales

If inventory grows at a much faster pace then sales it is a sign that a company isn't selling nearly as much as they thought they would. As you know inventory is much less valuable as time goes on after all how much is your computer worth that you bought 4 years ago? This works for just about any product not to mention the cost of a company to store and take care of inventory.

Another reason companies will inflate their inventories is because under the Generally Accepted Accounting Principles (GAAP) of absorption costing, companies have an incentive to produce more.  All of the overhead that would be attributed to each piece of inventory is pushed forward until the inventory is sold (costs are only recognized when something is sold).  This means that costs will be lower now, so that inflates net income.

The best way to avoid this problem is to go back to our trusty sales growth figure and then calculate the inventory growth rate each year and what percentage of sales this number is. If inventory grows too fast and sales start shrinking you should probably avoid the stock and go someplace else.

One Time Charges

A lot of companies will engage in activities that hurt it in the long term or have hurt it in the past. They will then suffer the consequences all at once, making their past and future returns look better then they really are. This problem is made even greater because most analysts take out non-recurring charges when reporting a company's earnings per share. Companies know this and are more than willing to do this when they have to so they can meet their expectations in the next couple of quarters. There is a good chance that $1.50 in earnings was really about $1.30 after the "one time" charges. Companies can do this in an already bad quarter in which they are going to miss estimates anyway so that they can report high earnings later. It is a bad sign that the company is going to great lengths to try and meet Wall Street expectations. This could lead to some very dangerous behavior if the company thinks they won't beat estimates again.

With all of this in mind, we hope that you will be able to understand a company's earnings a little better.  Just remember that things aren't always as good as they seem, so you need to make sure you do all of your research.