Introduction The third quarter earnings season just kicked off few days ago and investors are looking for signs of an improving economy. Several companies are expected report good earnings but be aware that better then expected results doesn’t necessary mean good results. Here are some things to look for in the up comings earnings reports.
Guidance.It indicates the outlook for the future. If earnings figures are reported to be better then anticipated but the guidance is lowered, then you will see some heavy selling.
Good sales. Better then expected sales figures means that demand is stronger then originally thought. It’s probably going to be hard to see higher sales number versus a year ago so growing sales since Q1 is good news. Once it’s established that sales are increasing, look for drivers of sales growth.
For credit card companies and banks: revenue attributed to large reduction in doubtful accounts seems unjustified given this economic environment and it represents a warning sign for potential revenue overstatement.
For banks: Due to joint ventures, mergers and acquisitions, some financial companies may indicate higher asset values or one time gains in the income statement. Look for how much asset growth is attributable to goodwill and carefully monitor changes in reported goodwill. Absence of impairments in this tough economic environment or increase in goodwill is a sign of low quality earnings.
Retailers: large portion of revenue accounted to LIFO liquidation is not sustainable and should be removed. The company is no longer purchasing additional inventory (prices are high) and is depleting its old and cheap cost-base inventory. Once it runs out of cheap inventory, it will have to purchase new inventory at a much higher cost base.
Computer software companies: with providers of goods and services sometimes there is discretion on deciding when a service has been provided. Revenue attributable to large decreases in unearned revenue is another warning signs as the unearned revenue account could be built up during periods of strong growth (customers prepay for service) and tapped into when times are tough like now.
EPS. It’s not necessary a good indication of growth in this economic environment because better net income can be the result of heavy cost cutting or one time tax credits.
Conclusion. Earnings have a tendency to revert back to normal levels (mean reversion) and very low or very high earnings are not expected to continue in the future. This has an economic meaning as capital migrates to more profitable businesses, increasing competition and reducing returns. The net effect of these competitive forces is a return to “normal” earnings levels