Staying on top of fundamental developments for companies in your portfolio can seem like a daunting task. Share prices can be volatile around earnings reports and trading updates, so getting to grips with what has happened and why is an important part of successfully managing investments.

This feature reveals three simple steps to demystifying a typical earnings report and getting a good steer on why a share price has moved in a particular direction.

Before starting it is worth emphasising that any report, whether annual or quarterly is merely a snapshot of how a company has performed over a very short period.

It is therefore important to apply some perspective. Long-term investors expect to hold shares for many years and to benefit from the growth of the business and associated cash flows, profits and dividends. In other words, a single earnings report is best viewed in the context of the bigger picture.

The bigger picture begins with the corporate strategy a company has employed to achieve its financial goals. An earnings report is therefore primarily an opportunity for investors to find out how the business has been performing against that strategy. It is also an opportunity to hold management to account.

THREE THINGS TO LOOK FOR IN EARNINGS REPORTS

1. How do earnings compare with expectations?

2. What is the outlook?

3. How much profit converts into cash flow?

WHAT IS ALREADY BAKED IN?

Step one is to discover how the business has performed relative to what was expected. This is important because markets are forward looking which means share prices discount what investors expect to happen. Note, this means share prices can move up on bad news and down on good news.

A good example is iconic footwear brand Dr Martens (DOCS) which on 30 May 2024 posted a 43% slump in annual profit. The shares rallied as much as 6% on the day because investors focused on the cost cutting announced and increased investment in marketing aimed at boosting sales.

Other contributing factors here are the several profit warnings issued over the last year which have resulted in downtrodden expectations going into the results.

So where does an investor find out what is expected? Helpfully, some UK companies provide consensus expectations either on their website or reference them in the earnings release.

For example, pet care specialist Pets at Home (PETS) included a reference to market forecasts in its first-half results released on 24 May 2024: ‘We are comfortable with current analyst consensus for financial year 2025 underlying pre-tax profit, currently circa £144 million.’

Failing that, free resources are available including Marketscreener and Nasdaq.com for US firms. Paid for resources include financial software providers such as Stockopedia and SharePad which give consensus sales and profit forecasts. Shares also regularly previews big earnings releases in our Week Ahead section.

The extent of an earnings beat can be significant because it can lead to upward analyst earnings revisions which can be a powerful driver of stock returns.

Therefore, getting a good sense of the likely move in earnings estimates, post results can be very valuable. Shares provides analyst comments and views while paid-for retail platforms such as Research Tree provide some access to analyst reports.

Step two is to read the outlook. A positive outlook is often found near the top of an earnings report while a negative one can sometimes be harder to find because the company’s public relations team have hidden it away near the bottom of the report.

The important takeaway here is that the outlook statement can often trump a positive earnings beat, which can sometimes catch investors off guard. There is some logic to this in that, investors place more weight on future earnings beats than past ones.

In general, shares in companies which upgrade the outlook on the back of a better-than-expected earnings release do better than those which do not.

An example is US retailer Dick’s Sporting Goods (DKS:NYSE) which on 30 May 2024 reported better than expected first quarter sales and EPS (earnings per share) prompting management to raise full year profit guidance above consensus estimates, sending the shares 16% higher.

HOW MUCH PROFIT WAS TURNED INTO CASH FLOW?

Step three is to find out how much profit was converted into cash flow. At the end of the day cash flow is more important than earnings. A typical way of measuring this is to compare cash generated from operations (found in the cash flow statement) with operating profit.

More and more companies calculate their own APMs (alternative performance measures). For example, Dr Martens calculates operating cash flow by starting with EBITDA (earnings before interest, tax, depreciation, and amortisation) and then deducts movements in working capital, share payments and capital expenditures.

The company converted 79% of EBITDA (£197.5 million) into operating cash of £156.8 million. The company says this is in line with guidance.

Every firm will target a different conversion ratio, and it is worth keeping a close eye on the trend in the conversion ratio over time. The higher the ratio the better the quality of those earnings.

PULLING IT ALL TOGETHER

A key question for investors following an earnings update is to establish how well the business is performing against expectations and the strategic plan. Is the business falling short or gaining momentum?

How do earnings compare with the trend over the last five years and are there any signs of acceleration or deceleration? Finally, try to place the latest update in the context of the bigger picture and long-term investment thesis. Bear in mind not all successful investments progress in a smooth linear fashion. 

What should be a prompt for a revaluation of a stock’s place in your portfolio is any sign of unexpected shift in strategy which brings with it additional risk or indications it is facing new structural problems which could put earnings under pressure. 

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