Earnings Explain
Earning reports are financial documents that describe the company’s performance over the last three months. They include the primary documents which are composed of the income statement, balance sheet and cash flow statement. These documents allow traders to evaluate the company’s profitability, performance, determine stock value and to hear from the company about any changes or news.
Earnings reports are generated quarterly, that is, every three months, and they are respectively named Q1, Q2, Q3 and Q4. Usually, the earnings report will be posted in the month following the end of the quarter. For example, the first earnings report is released at the end of the month of April, and it covers the company’s financial performance from January to March.
What do I need to look for in a company’s earnings report?
The main documents that need to be reviewed in an earnings report are the income statement, balance sheet and the cash flow statement. All these elements are equally important and allow us to evaluate how healthy the company is and how it is performing in comparison to previous quarters and the previous year.
Income Statement: This section of the report includes the company’s revenue, cost, operation income & expense, gross and net income. Basically, the income statement englobes all the expenses and incomes in regard to the company in a quarter. This includes the revenue made from selling their products to the expenses of the tools, materials and operational expenses to manufacture the product. In an ideal case, we want to see an increase in revenue and decreases in operating expenses.
Balance Sheet: The balance sheet is an update on the value of the company’s assets, liabilities and the total shareholder’s equity.
The total asset is the amount of cash that a company has in addition to the value in cash of all its assets. Asset can be anything from the company's building to a small tool. There are some assets that cannot be sold for cash and that will not be counted in the total asset of a company, and they are called non-current assets.
Liabilities are money that the companies owe. Current liabilities are debt that the company is planning to pay within the next 12 months. Non-current liabilities are debt that the company will be paid after a year or more. Liabilities of a company can be anything from an amount due to pay to a supplier of material to revenue that customer is paid, but the product is yet to be delivered. The total liabilities include current liabilities and non-current liabilities.
Total Shareholder’s equity is simply the total asset subtracted by the total liabilities. This is a great metric to verify if the shareholder is increasing over the years, meaning the total asset is increasing a lot more than the total liabilities or vice-versa.
Cash flow Statement: A cash flow indicates the result of the money going in and out of the company. If the cash flow is positive and increasing with time, then we can assume the company is healthy and going in the right direction. There are four primary cash flows. The first one is the cash flows from operating activities which indicates the company’s cash flow that they had generated from its activity for the quarter. The second cash flow is the one from investing activity, which can be any investment that the company made. It can be in the business itself or somewhere else. Financing activity consists of the third type of cash flow and includes debt repayment, common stock repurchases, dividend payments or other financial activities from the company. The last one is the net change in cash. This last section shows the amount in cash at the beginning of the quarter as well as at the end of the quarter.
What are Earnings per Share (EPS)?
Earnings per Share (EPS) is a metric used to evaluate the profitability of a company. Earnings per share is calculated by dividing the net income by the number of outstanding shares the company has. EPS are used to evaluate the company profitability quarter to quarter, it shows how a company is growing over time.
Earnings per Share (EPS) = Net Income / Number of Outstanding Shares
Notice that EPS is a good tool, but it is important to look at other financial numbers as well. The simple reason behind this is that EPS gives you a good idea of their profitability of the quarter but no other details. A company that is buying back shares will lower the amount of outstanding stock the company has, meaning EPS will increase. Hence, looking at the entire earning report is key to having a great understanding of how the company is progressing for the quarter.
Why does the stock price fluctuate on earnings?
Stock prices fluctuate on earnings in anticipation of good and bad earnings, rumors of new products and any other rumors or news that traders want to take advantage of the volatility of the stock price. A lot of time if there are rumors, traders will tend to buy at the rumors and sell at the news.
Another important element to understand as a trader is that even if a company has a good earnings report, it does not mean that the stock price will move to the upside. Sometimes, like mentioned previously it can be a sale of the new event. Therefore, it's very hard to anticipate the stock price movement prior to the earnings. The best play that can be done is to take advantage of the volatility of the stock and to be aware of the downside of your trade by keeping a tight stop loss.
How to analyse earnings reports numbers?
A great way to analyse these numbers is by comparing their financial performance in respect to the previous quarter or the same quarter for the previous year. A second of comparing the numbers to a competitor’s financial report in the same field to get a good idea as to where the company stands in regard to the field it is in.
What is Price to Earnings Ratio (P/E Ratio)?
The Price to earnings ratio is the result of the stock price divided by the earnings per share.
P/E ratio = Stock Price / EPS
A ‘perfect’ P/E ration will be 1. That means that the stock prices are proportional to the company’s growth in earnings. Any P/E ratio higher than 1, the stock price is considered overvalued and any P/E ratio in between 0 and 1 is considered undervalued. A perfect ratio of 1 is hard to find, however, in theory a P/E ratio of 2 or 3 is considered good. Some growth stocks can have over 80 of a P/E ratio and that is mainly due because investors believe that the company will be worth a lot more over time.