How Much Does An Earnings Report Tell You?
Corporations bombard average Americans with a vicious mix of half-truths and outright lies every moment of every day. You turn on the television and see fast-food burgers that in no way resemble the actual product at the drive through. You hear about a CEO promising their products' safety just days before it need be recalled. You read reports on pharmaceutical drugs that hide or manipulate data about efficacy compared to side effects. When it comes to investing in a company, make no mistake: the data released to the public may represent some of the picture at best and a flat-out falsehood at worst. As Q2 comes to an end, a bevy of corporations will release their earnings report in the grand hope of massaging their stocks' value. The market changes thanks to the lies, damn lies, and statistics dumped onto the heads of investors, but just what should you know about a company's actual earnings report?
Meet The New Boss
Imagine you earn a promotion to CEO of a Fortune 500 company (let's say it's Boeing because they make cool fighter jets). Upon looking over the massive balance sheet of various projects, products, and research, you take a red marker to whatever you find distasteful, ending dreams and careers and F-35s in one stroke. This practice, known as "big bath accounting", allows companies to write off a tremendous quantity of lost money when they liquidate sections and divisions of the company. Big bath accounting usually results in stock prices tumbling in the immediate aftermath of the decision. While poor stock performance often results in CEOs getting shown the door, a correction after a new corporate strategy becomes put into place sets up the stage for the stock to rebound and exceed both expectations and the market itself in the near future. Yet sometimes the stock price tumble and written-off value doesn't actually reflect the value kept by the company. A $2 stapler, for instance, can be written off as $1 in lost assets, then sold down the line for $3. Not only did the company profit from the decision, but those who bought company stock for a low value at the time earned better growth from the extra dollars. By carefully watching the news of corporate strategies taking on big bath accounting techniques, investors can capitalize following claims of lost value by comparing the stock against its previous lows.
Value, Value, Value
A company's assets may read like a grocery list: cash, equipment, real estate, inventory, accounts receivable. You can read over all the company's assets reported in their earnings and still not quite get the big picture for a variety of reasons, particularly that of investment assets. Companies label their assets as L1, L2, and L3. The first two usually involve stocks or bonds in addition to liquidity. Where L3 assets come to play lies a rather tangled web of value, given that L3 assets may be valued based on managerial input rather than on accounting. A company with large quantities of L3 assets, as such, may prefer to play the game by their own rules and create value based on their own needs. A private equity investment, mortgage assets, foreign options, and derivatives all come to play under the umbrella of L3 asset classifications. Since these rarely trade publicly and rarely trade one-for-one, a company can effectively claim whatever value they desire -- much in the same way that a diamond seller may put whatever value they desire on a diamond given that no valuation exists other than what a customer may be willing to pay. Part of the 2008 financial crisis involved L3 assets with mortgage backed securities given that the underlying mortgage had only the value agreed between two parties; one of whom defaulting or failing to adjust prices led to a massive domino effect. Investors need keep a very keen eye out for earnings reports with heavy markups of L3 assets given that they may be worth billions or may only be worth the paper and ink needed for the printer itself.
Assets come into this world with a shelf life and once they reach that date, they appear no more palatable than mayonnaise that has also reached its expiration date. Of all the countless billions of assets tied up in Apple Computers, for instance, nobody considers the assets pertaining to the original Macintosh to still retain any value. Yet companies manipulate the slippery slope of depreciation in order to ratchet up the salvage value of any particular asset, generating better bottom lines when it comes to revenue and boosting the overall all-important profit/expense ratio. Rather than look at depreciated assets as a measuring stick of a company's earnings, investors should look into the useful life of an asset (a term and valuation mechanism with far less wiggle room) in order to determine true value of depreciated assets. In addition, rooting deeper into the numbers to determine a company's depreciation method relative to their competitor will allow you to see which companies err on the side of caution and which err on the side of putting lipstick on a pig.
In addition to the broader points of an earnings report, a critical investor should look at simple trends. A company that frequently changes their accounting mechanism, for instance, should no more be entrusted with your valuable money than a company selling magic beans. The ratio of capitalizing compared to expensing will tell you a lot about a company: stockholder equity grows in the short-term by capitalizing assets but outperforms in the long run by expensing assets. Finally, and perhaps most importantly, remember that the market has already reacted to earnings reports far faster than any individual ever could. If you hear of a stock with nothing but good news backing it up, investigate the earnings report to see if forecasts for the next quarter sit well above the last quarter. If not, you've simply been beaten to the punch.