Credit: Shutterstock photoA critical part of the process of evaluating the underpinnings of stocks is understanding the information companies report during what's known as earnings season.
The essential parts of those reports are revenues (how much they received from products sold or services provided) and earnings (how much profit they made). For companies reporting their quarterly results to the public on a calendar-year basis, there are four key reporting periods: late January/early February, late April/early May, late July/early August and late October/early November. These are known as the earnings seasons.
The earnings seasons are when companies tell the public how they are performing. These are the times when stocks tend to be most volatile, occasionally due to results that are better or worse than what was expected. (For more, see: Become Your Own Stock Analyst.)
Why Earnings Reports Matter
The focal point of earnings reports is the bottom line: Did the company do better than it did in the year-earlier period, and by how much, or vice-versa? The response to that question barely scratches the surface of what investors need to know, but in most cases the formula for a proper assessment of what has been reported is not that complicated.
Here's the pecking order of how reports work: If both revenues and earnings are rising, that's usually the most promising combination. If earnings are rising, but revenues are not, that may or may not be problematical. When both revenues and earnings are falling, it's probably time to bail out.
Rising Revenues and Earnings: A Good Sign
When the numbers are reported, an encouraging result is when both revenues and earnings are climbing. That's especially so when the gains are part of a consistent, long-term pattern. It means that there's growing demand for the company's goods or services and it tends to suggest that there will be more of the same in the future. That's what investors like.
Even so, there are footnote items that need to be checked. It's important to learn whether there has been a significant reduction in the number of shares outstanding. If so, that would tend to exaggerate the gain in profit per share. Also, make sure to check whether the revenue number included any nonrecurring items such as income from a sale of assets. Nonrecurring gains temporarily help cash flow, but they should not be included when reviewing stock valuations.
Higher Revenue and Lower Earnings: Likely Okay
Rising revenues accompanied by lower earnings may or may not be a problematical indication. Sometimes, this apparent mismatch may be the result of a product introduction that is being supported by heavy marketing expenses. This is a typical situation, especially for new products with big potential. As time passes and marketing costs taper off to normal levels, this may translate into a resumption of earnings growth. That's a common situation, but not every new product succeeds. (For related reading, see: How to Decode a Company's Earnings Reports.)
Higher Earnings, Lower Revenues: Raise the Caution Flag
If earnings are rising when revenues are lagging, that can mean a number of things. Sometimes when companies are facing a difficult market, they will emphasize cost cutting to keep profits climbing. In the absence of top-line gains, however, this approach will have a limited life and will not inspire investor confidence.
It is possible to keep earnings advancing when revenues are slipping by using cash to buy back company shares and by selling less productive assets, but these are obvious gimmicks that do not inspire confidence among Wall Streeters. What investors insist upon is consistently sustainable earning power. If what's going on doesn't support long-term growth, that's bad news.
Revenues and Earnings Heading South: Bad Sign
When both revenues and earnings are being reduced for more than a short period, that's likely to be ominous. It could mean that the company has not kept up with the market or perhaps management is no longer effective in steering the ship. Whether it's one of these possibilities or another, it's bad news for the shares and often time to sell, if you haven't already done so.
Guidance on What's to Come
When quarterly reports are released, it's common for companies to issue guidance on what lies ahead. If future expectations are raised, that's a good sign, often likely to boost stock prices. Whatever the case, any changes in what's to come will be closely scrutinized by Wall Street.
And then there's the matter of the whisper numbers. These are the estimates that are talked about by industry professionals based upon their own research. Sometimes they are significantly different from what the companies provide as guidance. When the numbers reported don't come up to the level of the whisper numbers, it should come as no surprise that the shortfall will lead to a dip or plunge in the price of the stock.
When reading what companies have to let us know about how they are doing, use this information as a yardstick to get a better handle on where they really stand.
(For more from this author, see: Avoid Hot Stock Tips and Focus on Fundamentals.)
This article was originally published on Investopedia.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
