The Importance of Earnings Report Analysis As An Investor
Analyzing earnings reports is one of investors' most important tools for judging a company’s health. They provide investors and analysts with vital information to assess a company's financial standing and future prospects. Understanding why earnings reports are important can help investors make informed decisions and navigate the complex world of stock markets.
What Is An Earnings Report?
All publicly traded companies are required to issue quarterly earnings reports (10-Q) and an additional annual report (10-T) at the end of their fiscal year. These quarterly reports are official financial documents issued by public companies that show expenses, earnings, and overall profit for a specific period. They allow investors to compare a company to rivals and companies and assets in different sectors to determine how best to allocate their money.
Why Earnings Reports Are Important
Earnings reports give shareholders, investors, and the wider public a complete picture of a company’s health and profitability. They provide transparency into a company’s operations, and help to keep company executives accountable. Earnings reports can have a major impact on a company’s share price, depending on whether they meet, beat, or miss market expectations.
Key Numbers In An Earnings Report
Each number in an earnings report is compared to the previous quarter and the same quarter of the previous year. Every number in an earnings report is important, but some carry more weight than others. The two most important numbers to analysts and investors are revenue growth and earnings. Together, these two pieces of information are invariably the ones quoted in the news about an earnings report.
Revenue Growth
Revenue, or gross sales, records the total amount earned during a quarter or fiscal year before expenses. It is also known as the “top line” since it appears at the top of the income statement. Revenue growth is a key metric in determining other aspects of a company’s health.
Earnings Per Share (EPS)
Earnings per share (EPS) indicates a company’s profitability by dividing net income by the number of shares of stock. Even more than revenue growth, EPS determines a company’s performance and share price. For this reason, investors should investigate how company management is calculating it.
Price/Earnings Ratio (P/E Ratio)
The P/E ratio is simply a company's share price divided by earnings per share. The P/E ratio shows how much stock an investor would need to buy to capture $1 of the company’s earnings. Forward P/E ratios can be calculated by using estimated forward earnings. They are often used to assess rapidly growing companies. Care must be taken to judge the accuracy of a company’s earnings forecast, partially by comparing analysts’ estimates against a company’s forecast and by management’s history of over- or under-stating earnings projections.
Return On Equity (ROE)
Return on Equity measures how well a company generates profits from shareholder capital.
Simply put, it is calculated by dividing a company’s net income by total shareholder equity. ROE provides a conservative measure of a company’s value.
Debt-To-Capital Ratio (D/C Ratio)
The debt-to-capital ratio measures a company's debt load. It is calculated by adding short- and long-term debt and dividing it by total capital. Highly leveraged companies run a greater risk of being unable to service their debt. A high D/C ratio can also indicate that a company is using debt to operate to make up for revenue shortfalls.
Interest Coverage Ratio (ICR)
The interest coverage ratio (ICR) is another way to determine whether a company can support its debt load. It is calculated by taking earnings before interest and taxes (EBIT) and dividing by the interest expense. ICR tells you to what extent earnings cover interest payments due to the company’s bondholders.
Enterprise Value to EBIT
Enterprise value to EBIT is a more inclusive version of the P/E ratio that includes debt financing. To get a company’s enterprise value, add a company’s interest-bearing debt, net of cash, to its market capitalization. Like the P/E ratio, the EV/EBIT ratio allows investors to compare a company’s actual operating earnings to other companies, even if they have different tax rates of debt loads.
Operating Margin
Operating margins are another important measure of a company’s profitability. A company with larger margins earns more profit per dollar. Operating margin is calculated by dividing operating profit by total revenue of its core operations to discover how much income is generated by each dollar of sales. (Operating profit is gross profit minus operating expenses, depreciation, and amortization.)
Operating margins allow you to compare companies without needing to make adjustments for debt financing or tax rates.
Quick Ratio
The quick ratio measures the ability of a company to cover short-term obligations using liquid assets. The quick ratio becomes more important when a company is facing financial difficulties where its ability to cover its liabilities may come into question.
The quick ratio is calculated by adding up a company’s cash, accounts receivable, and marketable securities (stocks or bonds) and then dividing the sum by current liabilities. A company’s inventory is not included since it can’t be quickly converted to cash.
A quick ratio of one or less is a warning sign that the company needs to raise additional funds or hope for an immediate improvement in revenue.
Conclusion
Earnings reports have many moving parts that must be taken together to perform a proper analysis of a company. Other less concrete factors also need to be considered, such as management’s record in running the company and the accuracy of their forward guidance.
