Earnings: What Are They And What Story Do They Tell?
By Andy Nugent, CFA®
Every quarter, publicly listed companies report their earnings per share. The investing world waits anxiously for these numbers, asking, “Will the number be higher than expected? Will they beat their guidance? Does it matter?”
Earnings per share is the most easily manipulated number on the income statement. Depending on the accounting method, a company can sway the true earnings in several ways. Let’s look at how that happens and an alternative approach to analyzing earnings.
The Real Story Behind Earnings
For one, reported earnings can be exaggerated by a one-time sale of an asset. This will increase earnings and make the company look inexpensive on a price-to-earnings basis. This may cause someone to purchase the company only to see earnings revert to the normal number in the next quarter. In the same manner, a company may employ accelerated depreciation to lower earnings. This helps the company save on taxes but may make the price-to-earnings ratio higher than it should be and look less desirable to unsophisticated value investors.
Due to the ease in manipulating earnings, try looking at operating cash flow instead. Operating cash flows are much more difficult to manipulate and give a clearer view of how a company is doing quarter by quarter on a cash basis. It adds back non-cash expenses such as depreciation and considers inventories and accounts payable and receivable. Investors can use this number to compare with quarters past to see an average multiple of price-to-cash flow the company normally trades. Use conservative assumptions to determine if the company is trading at a discount and may be a good fit for your overall portfolio.
Using cash flows to value companies works best with slow-growing or mature companies that may be out of favor. You can use this strategy to value growth companies as well, but assumptions of future cash flows will likely be less accurate as the actual growth components change more rapidly.
We Can Help
If you want to make the right decisions for your portfolio but don’t know what information to rely on, our team at Sage Capital Advisors can help you implement investment strategies that help you stay on track toward your goals. Contact us at (844) 279-7243 or by email at firstname.lastname@example.org to get started.
Andy Nugent is director of investments at Sage Capital Advisors, LLC, an independent, fee-only boutique wealth management firm based in San Diego, California. Andy got his start in the financial world at a young age when his grandfather bought him stocks and taught him about the markets. With 21 years of experience, Andy is passionate about building personalized portfolios and developing lasting relationships with his clients. He strives to help his clients achieve their investment goals so they can be free to pursue the life they desire. He is known for going the extra mile for his clients and doing everything in his power to manage their assets wisely and successfully. Andy knows he’s done his job well if his clients can sleep better at night because of their confidence in his ability to prepare them for their financial future. Andy has a bachelor’s degree in finance from San Diego State University and is a Chartered Financial Analyst® (CFA®) professional. When he’s not faithfully serving his clients, Andy loves being with his family. You can usually find him spending his weekends watching his two daughters play competitive softball on a random softball field somewhere in Southern California! To learn more about Andy, connect with him on LinkedIn.