How to Better Read Earnings Reports

Earnings season will soon be upon us again. The market will be looking to reward those companies that come in with higher-than-expected earnings and to punish those firms that disappoint.

However, there will be cases where one company beats by a small amount, say $0.05 or 2.5%, and there is a big jump in the price of a stock in reaction, but on the same day there might be another firm that beats by $0.10 or 10%, and it is treated as a relative non-event by the market. Why is that?

Well, too much of the emphasis will be one-dimensional — by what percentage or dollar amount did the actual result come in above or below the estimate? The significance of a percentage beat also varies greatly by the level of the estimate and actual. Beating by $0.02 is a much bigger deal if the consensus was looking for $0.05 than if it was looking for $5.00.

However, I would be (all else being equal) much more impressed by a company that beat by 40% if the expectation was for $5.00 and the actual was $7.00 than if the expectation were $0.05 and the actual was $0.07. While without a doubt, the size of the beat — both in dollar terms and in percentage terms — is an important metric, it is not the only one you should be concerned about. Remember that the consensus estimate is an average (mean) of all the estimates out there. Two companies could each have, say, 10 estimates and a consensus estimate of $1.00.How the Actuals Reflect the Estimates

The estimate profiles might be very different. Let us suppose that in one case, those 10 estimates range between $0.98 and $1.02. In another case the estimates range between $0.50 and $1.50. Now let us suppose that both companies report earnings of $1.05 (and we will also suppose that there were no other significant differences in the quality of earnings or one having whisper numbers that were significantly different from the “official” consensus expectations). Which company do you think would likely have the bigger reaction in the market? The one with the tighter consensus.

The posting of $1.05 would represent substantial new information about the prospects for the company. The results would have been well above what the most optimistic analyst had been looking for. For the second company, that same $0.05 and 5% beat would be essentially a non-event. It will not really force the analyst who was expecting $1.50 to become more optimistic. The analysts at the low end might be inclined to move up a bit, but the beat would most likely be considered almost random noise.

Leverage comes in two basic flavors — financial and operational. Companies with a lot of debt can do very, very well if things go right, but things can quickly turn disastrous if things go wrong. Equity investors get the residual after everything else is paid off. Interest on debt has to be paid before the profit. Those costs, though, are generally fixed (unless the debt is mostly variable rate).

Why would there be such a difference in the spread between the two companies? Some companies are just generally easier to forecast. Generally speaking, the more leverage a company has, the harder it is to come up with an exact and accurate forecast.Leverage Can Be Key

If a company is expected to bring in $1 billion in revenue for the quarter by spending $990 million (including interest costs), then the expected earnings are $10 million. Now suppose that it is able to generate $1.01 billion in revenues. If the costs are fixed then that extra $10 million drops to the bottom line (OK, at least to the pre-tax line).

The result is a huge earnings surprise: 100% if we ignore taxes (or if the company has things like tax loss carry forwards). That from just a 1% better performance on the top line.Volatility in Other Forms

Interest is not the only fixed cost. Some firms can have pristine balance sheets and no interest expense at all, but still have very volatile and unpredictable earnings. A great example of that sort of firm is the money management business.

It does not take any more brains or manpower to run $1 billion than it does to run $2 billion. The only real difference is the number of shares the fund management company buys. In the short term, the vast majority of expenses (mostly wages for analysts, portfolio managers and client contact people) are not going to change. Since the fees are generally a fixed percentage of assets under management, if those go up, earnings soar, if they go down, profits plummet.

On the other hand, a retailer will only be able to generate higher revenues if it also buys more inventory to sell. Rising revenues demand rising costs. The extent to which costs are fixed generally determines how sensitive earnings are to changes in revenues. The higher the sensitivity, the more difficult it is to forecast the earnings.

More tips to reading an earnings report.

Dirk Van Dijk writes for Zacks Investment Research market strategy.

“The information supplied above by Zacks Investment Research Inc. contains opinions based on factual research which may or may not be accurate. Neither Zacks or Intellisphere will assume any liability for losses from investment decisions based on this information.”