Every investor needs to know how to analyze earnings reports, because they're one of the most important tools investors have.
Earnings reports measure a company's financial health and help investors gauge whether or not a company's stock is a strong investment.
Each publicly traded company files an earnings report every quarter. It's considered a "report card" because it tracks performance metrics like revenue, cash flow, and operating costs.
But investors need to dig deeper into every earnings report and know how to decipher these numbers.
Here's our four-step guide on how to analyzing earnings reports...
How to Analyze Earnings Reports No. 1: Focus on the Key Metrics
The most important metrics of an earnings report are revenue and earnings per share (EPS). These are the first numbers every investor looks for when the report comes out.
EPS is called the "bottom line" of an earnings report because it's displayed at the bottom. It's the portion of a company's profit distributed to each share of stock. It can be calculated by dividing the company's profit by the number of outstanding shares.
Each earnings report breaks the metric down into basic EPS and diluted EPS. Basic EPS only concerns a company's total number of shares, whereas diluted EPS concerns all shares, options, bonds, and other securities.
Diluted EPS helps investors determine a share's price and a company's profitability. That's because it takes all types of company assets into account rather than just outstanding shares.
Revenue, on the other hand, is the "top line." It's the total amount of money a company rakes in each quarter. Revenue is synonymous with "gross income" and is simply the price of a company's product multiplied by the number of products sold.
Here's how you can use EPS and revenue numbers to measure a company's financial health...
How to Analyze Earnings Reports No. 2: Compare the Key Metrics to Expectations
The next step is to compare revenue and EPS to Wall Street estimates.
Many Wall Street banks and research firms project a company's EPS and revenue ahead of earnings. These forecasts provide a good comparison point for the quarterly results.
And Wall Street expectations can have a huge influence on a stock's performance. Even if a company's earnings grow from the previous year, its stock can still plunge if it misses estimates.
This happened to Alibaba Group Holding Ltd. (NYSE: BABA) stock after reporting earnings on Aug. 12. BABA stock fell 8.2% after the e-commerce giant reported revenue of $3.26 billion, which missed estimates of $3.39 billion. However, revenue increased 23% from the same period in 2014. BABA investors who ignored the Wall Street panic and held onto the stock have seen a 10.9% rebound since then.
While Wall Street projects EPS and revenue, it will also predict numbers pertinent to each company...
How to Analyze Earnings Reports No. 3: Identify Company-Specific Factors
While revenue and EPS are universal, a company may report a specific metric that plays a key role in its business. These company-specific factors can make or break the stock.
A specific number investors look at when Apple Inc. (Nasdaq: AAPL) reports earnings is iPhone sales. The iPhone is the primary focus of Apple earnings because it accounts for roughly two-thirds of the firm's revenue and profits. In fact, Apple stock is up more than 600% since the introduction of the first-generation iPhone in 2007. That shows how investors consider iPhone sales just as important to the company's growth as the top and bottom lines.
Another specific metric used by Facebook Inc. (Nasdaq: FB) and Twitter Inc. (NYSE: TWTR) is monthly active users (MAUs). MAUs measure the number of people who actively use a website in any given month, regardless of when those users first started using the service. Facebook reported 1.55 billion MAUs in the third quarter, up 14% from last year. Meanwhile, Twitter reported only 320 million MAUs, up 11% over the same period.
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Before investing in a stock, you need to know which company or industry specific factors to look for and how the company is performing in that area.
While revenue, EPS, and company-specific terms are the most important, there are other earnings metrics you should understand...
How to Analyze Earnings Reports No. 4: Be Familiar with These Other Terms
Here are more metrics investors should look for when analyzing earnings reports...
- Operating Margin: the amount of a company's revenue left over after paying for costs of production, including wages and raw materials.
- GAAP Net Income: a company's total profit reported using the SEC-required generally accepted accounting principles. GAAP include classifying balance sheet items and meticulously measuring outstanding shares. Companies are expected to follow GAAP rules when reporting financial data.
- Non-GAAP Net Income: a company's total profit reported without the use of generally accepted accounting principles. Some firms report non-GAAP earnings in addition to GAAP earnings if they believe the non-regulated numbers more accurately reflect performance.
- EBITDA: earnings before interest, taxes, depreciation, and amortization. EBITDA is the most important non-GAAP metric. It offers a greater amount of discretion as to what's included in net income and revenue.
- Outlook: a company's estimate for its future quarterly or annual earnings. These show if the company is projecting to grow in the next quarter or year.
Alex McGuire is an associate editor for Money Morning. You can follow him on Twitter at @AlexMcGuire92.
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