How to read a quarterly earnings report without getting lost
Revenue, margins, GAAP versus adjusted figures, diluted EPS and guidance: a step-by-step way to read a company's quarterly results.
Every three months, public companies in the United States publish their results. The headline number that reaches the news, usually earnings per share compared with what analysts expected, is only a small part of the story. A company can "beat" on earnings while its core business weakens, or "miss" while making sensible long-term investments. Reading the report yourself, in a fixed order, is the quickest way to tell the difference.
Know which documents you are reading
Most companies release results in two forms. The earnings press release comes out first, usually before the market opens or after it closes, and is filed with the Securities and Exchange Commission as an exhibit to a Form 8-K. The Form 10-Q (or the Form 10-K for the fourth quarter and full year) is the formal quarterly report. It is longer and includes the full financial statements, notes, risk factors and management's discussion and analysis. The press release is written to be read quickly; the 10-Q is where the detail and the caveats live. Both are free on the SEC's EDGAR database.
Start with revenue, and ask where it came from
Revenue, sometimes called sales or the "top line", is the money a company earned from its customers during the quarter. Compare it with the same quarter a year earlier rather than with the previous quarter, because many businesses are seasonal: a retailer's holiday quarter is not comparable with its spring quarter.
Then look for the breakdown. Most companies report revenue by segment, product line or region. A 6% rise in total revenue can hide a 20% jump in one division and a decline everywhere else. Watch for acquisitions too: revenue that was bought is different from revenue that was grown, and companies often report "organic" growth that strips out deals and currency movements.
Move down to the margins
Next, look at what it cost to earn that revenue. Gross profit is revenue minus the direct cost of producing the goods or services sold. Operating income subtracts the costs of running the business, such as salaries, research, marketing and rent. Net income is what is left after interest, taxes and one-off items.
Each of these, divided by revenue, gives a margin. Margins tell you whether growth is healthy. If revenue rose 10% but operating income rose only 2%, costs are growing faster than sales. That may be deliberate, for example a company hiring ahead of a product launch, or it may be a sign that pricing power is fading. The explanation is usually in the management discussion section of the 10-Q.
GAAP and "adjusted" figures
US companies must report results under Generally Accepted Accounting Principles (GAAP). Many also publish non-GAAP or "adjusted" figures that exclude items such as stock-based compensation, restructuring charges, amortization of acquired intangible assets or legal settlements. The SEC's Regulation G and related rules require companies that publish a non-GAAP measure to present the most directly comparable GAAP measure and a reconciliation between the two.
Adjusted numbers can be useful, because a one-time lawsuit settlement tells you little about next year. But read the reconciliation table. If the same "one-time" charges appear every quarter, they are a cost of doing business. And if the gap between GAAP and adjusted earnings keeps widening, ask why.
Earnings per share: basic and diluted
Earnings per share (EPS) is net income divided by the number of shares. Basic EPS uses the shares actually outstanding. Diluted EPS also counts shares that could be created from stock options, restricted stock units and convertible securities. Diluted EPS is the more conservative figure and the one most analysts compare.
EPS can rise even when profit is flat, if the company has bought back shares and reduced the share count. That is not necessarily bad, but it is different from the business earning more. Check whether net income and EPS moved together.
Cash flow: the check on everything else
Profit is an accounting measure; cash is what pays the bills. The cash flow statement shows how much cash the business generated from operations, how much it spent on investment such as equipment and acquisitions, and how much it returned to shareholders or raised from lenders.
A useful habit is to compare operating cash flow with net income over several quarters. If a company reports steady profits but operating cash flow is consistently lower, look at receivables (customers who have not yet paid) and inventory. Growing faster than sales, either can be an early warning. Many companies also report "free cash flow", usually operating cash flow minus capital spending, but there is no single official definition, so check how each company calculates it.
The balance sheet in two minutes
You do not need to analyze every line. Look at cash and short-term investments, total debt and when it comes due, and whether shareholders' equity is growing or shrinking. A company with a lot of debt maturing in the next year and falling cash has less room for error than the headline results might suggest.
Guidance and the call
Many companies give "guidance", a forecast for the next quarter or full year. Markets often react more to guidance than to the quarter that just ended, because the past is already known. Note whether guidance was raised, maintained or cut, and whether it is given as a range. Guidance is not required and is not a promise; it is management's estimate, and it comes with forward-looking-statement warnings for that reason.
The conference call that follows the release is also worth a look. The prepared remarks repeat the press release, but the question-and-answer session often reveals what analysts are worried about. Transcripts and recordings are usually posted on the company's investor relations site.
A simple reading order
- Revenue versus the same quarter last year, and the segment breakdown.
- Gross and operating margin, and the reasons given for any change.
- The GAAP-to-adjusted reconciliation.
- Diluted EPS and the share count.
- Operating cash flow compared with net income.
- Cash, debt and upcoming maturities.
- Guidance, and what changed from last quarter.
Followed in that order, a report that looks like a blur of numbers becomes a short list of questions, and most of the answers are in the filing itself.
This article is general information, not investment advice.