Earnings season is in full swing, the time has come for companies to make their pitch to investors. Have they performed as expected over the last 3 months, or has their business changed in some measurable way? Questions will be answered, and predictions given as the cycle continues. Investors need to understand what is being reported and why it may be good or bad news.
Top-line revenue is the starting point for an earnings release. Also referred to as sales or gross revenue, this number represents the total income derived from primary operations. While many adjustments are made to this, it is still an important measure of business activity. Revenue can be derived from selling a product, running a subscription, or providing a service. Change in revenue can often indicate whether a business is gaining or losing traction in its market. A company that consistently increases its revenue will be considered more favorable than one with inconsistent revenue streams.
After revenue comes expenses. Various categories of expenses are reported depending on the type of business. A manufacturing firm will have input (raw goods) costs, while a software firm pays for intellectual capital. Service providers will often report the cost of customer acquisition. The moral of the story with expenses is understanding their relation to revenue. Is the company keeping costs in line with revenue? A firm spending far more than its competitors to achieve similar revenue will not fare well. Are rising expenses resulting in increased revenues? This is a sign of management’s ability to properly direct resources and priorities in the company.
After revenue and expenses are reported, and many accounting mechanics are implemented, we end up with profits. Whether labeled “gross”, “operating”, or “net”, profits are the results of creating a good or service and selling it to your customer. Is this firm reliably able to profit from its business activities? A worthy investment will show strong profitability and the ability to protect those profits during various market cycles. Prolonged declines in profitability are a clear sign of hard times ahead.
Depending on your news source, you are unlikely to see these numbers broken out in the media. What you will see is Earnings per Share (EPS). This metric simply breaks down your share of earnings based on the amount of the business you own. Remember, as shareholders, we are owners of the business. Each share represents a claim on future earnings. EPS is important in that it’s a key component of the Price to price-to-earnings ratio (P/E). P/E is a measure of the price investors are paying for a share of that firm’s future earnings. Example: ABC Co. earns $10 per share on an annual basis. Investors are willing to pay 10 times annual earnings to own a share of the company, resulting in a share price of $100. Analysts use this and other metrics to project future stock prices based on expected earnings.
There are many additional ways to value a company. At the end of the day, you want to know how a company makes their money, and their prospects for continuing to do so. Warren Buffet said it best, “Only buy something that you’d be perfectly happy to hold if the market shut down for ten years.” He was often caught devaluing the whole process of quarterly reporting to begin with. Managers with quarterly mindsets often prioritize the short-term over long-term value creation. If your goals are long-term, seek investments that align with long-term value creation.
