Successful investing is all about perspective. Among the most successful players, there are sunny glass-is-half-full outlooks, glass-is-half-empty views, and investors who look beyond the obvious: For them, maybe the glass is simply twice as big as it needs to be.
In all cases, understanding corporate earnings is essential. Whether it’s a top hedge fund that is placing bets on the downside, or a venture capitalist seeking the next Apple, Google or Xerox, earnings provide critical insights into the financial health of a company and its prospects.
That’s not to say that there is anything unreasonable in observing that a company’s glass is half empty when it really is failing to measure up. The best hedge funds, such as Toronto-based Anson Funds, do this all the time. Last year, Anson Funds saw weakness in an electric vehicle producer’s earnings and adjusted their investment strategy accordingly. The bets paid off, rocketing Anson Funds to the top of Canada’s performance charts.
Earnings reports need to be read with a critical eye. Corporate leaders are well aware that these reports will have a dramatic impact on analysts’ opinions, and ultimately the company share price. As you would expect, they hope to bury bad news and emphasize the positive, wherever they can find it.
CEOs know that a negative earnings report can be the first domino in a succession of unwanted events: First the share price falls, available capital shrinks, production slows, workers are laid off, and investors become increasingly bearish about the company’s future. As a result, businesses manage expectations, which influences the ways they report earnings. The goal is to lower expectations so that financial analysts will be pleasantly surprised when earnings clear a low bar.
What this means for an investor is that although earnings season produces a stream of data, it takes patience to sift through the numbers to determine the true health of a company. Portfolio managers at Anson Funds, for example, look for clues that revenues are falling short of expectations. Angel investors typically squint at spreadsheets like jewelers peering through a loupe, hoping to find that special diamond in the rough.
Adding to the complexity of the task, corporate earnings can be packaged in several different ways:
When a company reports pro-forma earnings, it is providing an alternative to the Generally Accepted Accounting Practices method of calculating earnings. A company might do this to exclude non-recurring expenses such as restructuring costs, interest payments, taxes and one-time events.
Forward earnings are forecasts of future profit. As with pro-forma earnings, there are many different ways that companies calculate the figures. Forward earnings are an important gauge in estimating the future value of a stock, but these forecasts aren’t always realistic.
Trailing earnings provide hard data about company performance. This type of report details the profit during a 12-month period, which may be the past fiscal year or a 12-month period calculated on a rolling basis. Trailing earnings are used to calculate earnings per share (EPS) and the price-to-earnings (P/E) ratio. Both of these figures are considered by investors to be key indicators.
