An Easy Way to Predict Stock Performance

An Easy Way to Predict Stock Performance

Imagine if, every three months, you had to issue a report on how much money you made and how you handled your finances—and then the world judged you on it.

It would probably spur you to make a lot of money, handle your finances as well as you possibly could— and maybe even try to cover up any mistakes (or at least put a positive spin on them). Basically, you would put out the most flattering report possible.

This, in a nutshell, is what public companies do periodically (usually four times a year) in what is called an earnings report.

Public companies are those that have issued stock that you (or your mutual fund manager) might have bought. And for the last month or so, many companies have been reporting on their third-quarter 2011 results.

This week, for instance, several big-name companies—Wal-Mart, Target, Lowe’s and Dell—issued earnings reports. While earnings reports may contain a lot of technical language that seems understandable only to money managers, they're actually pretty easy to decode.

And learning to do so can help you make better investments.

What You Need to Pay Attention to in Earnings Reports

Earnings

As you might expect, an earnings report is mainly about one thing: earnings. The technical definition of earnings is simply profits during the reporting period. And profits are what you have after you pay taxes and subtract your expenses from your income:

Income – Taxes – Expenses = Profit/Earnings

So, if you were to dissect the opening line of the Wall Street Journal’s story on Target’s earnings, you’d get this: "Target Corp.'s fiscal third-quarter earnings (Target's third-quarter profits) rose 3.7% (went up a bit) as same-store sales grew (as more money came in) and the retail giant's bad-debt expenses declined (and less money went out)."

Earnings tends to be one of the top determinants of stock price, because profitability is one of the best indicators of whether the company will be successful over the long haul.

Earnings Per Share

Earnings per share (EPS) is just what it sounds like: how much profit the company earned divided by the number of shares in the company. So, if a company has $10 million in profits and there are ten million shares, the earnings per share is $1.

In the Target example, the company reported $555 million in profits in the third quarter. When divided by the number of shares (more than 675 million), that amounted to 82 cents per share.

One criticism of the earnings-per-share measure is that it can be calculated in several ways, which can also be demonstrated with Target’s report this week. When the retailer excluded certain one-time expenses, such as costs to expand in Canada, its earnings per share was 87 cents per share. Some news articles even printed the 87-cents figure, while others reported the 82-cents one. Both are right—they just represent different ways of calculating the number. (However, in this example, 82 cents represents the more common way of reporting the number—to do so without excluding special one-time expenses.)

To illustrate what it means to exclude one-time expenses, let's say you were creating your own report. You might say, well, for the third quarter of 2011, I had a profit of $1,000. But since I had a surprise dental bill of $500 that isn't a part of my regular expenses, I actually would have had profit of $1,500 if this had been a "business as usual" month.

But beware of these one-time charges. Companies sometimes use them to explain away expenses that actually are central to their business.

Expectations

Although many people say that earnings per share can be manipulated, this number ends up determining whether the company has “beat expectations” (which would drive its stock higher) or “missed earnings.”

Expectations refer to projections that Wall Street analysts and other investors make before a company issues its report to try to predict how well a company did during its quarter.

In the case of Target this week, analysts predicted earnings of 74 cents per share on $16.27 billion in revenues. Whether you’re looking at the 82-cents-a-share figure or the 87-cents-a-share figure, Target blew away expectations.

Often, when the company’s earnings come in higher than Wall Street estimates, the company’s stock rises, though not always. On Wednesday, Target’s stock price rose in the early part of the day, but finished the day lower (possibly because people who bought the stock when it was lower were happy to lock in their profit now and sell to new buyers, who are betting that Target stock will rise even further).

However, expectations are a double-edged sword, because if a company misses them, it's in the corporate doghouse. Take Walmart. For the third quarter, the company missed expectations with earnings of 96 cents per share, compared to Wall Street estimates of 98 cents per share. As expected, its shares slid the next day.

Then again, even if the company beats expectations on profit, its stock can still take a beating if it misses expectations in another area, such as income, typically called revenue.

For instance, Dell, which released its earnings Tuesday, beat expectations on earnings, but it “missed” revenue estimates—earning $15.37 billion, which was less than the $15.65 billion analysts had projected. Even though their profits were higher than expected, having lower income than expected was enough to drive its stock price down.

The fact that Dell stock was punished even though the company showed a profit demonstrates how powerful expectations are: Since it didn't beat those revenue expectations, people decided to sell.

Bottom Line

When understanding a company’s earnings reports, the two numbers people are likely to compare are earnings (or earnings per share) and expectations. Basically, if you make more money than people thought you would, they will reward you for it, and if you don't ... well, they don't.

If you own stock, check out the news articles about its earnings every quarter to make sure your investments are on track. But don't fall into the bad habit of dumping a stock every time it misses its earnings by a few cents. Pay attention to the bigger picture—how it's doing compared to other companies in this economy, or in its sector; whether you see an up trend or a down trend in a company's revenues or profits over the course of a year; whether its expenses are staying in line or getting too high for your taste.

If you invest in a company (whether directly or by owning a mutual fund that invests in it), then its financial health is directly linked to your own financial health. So, pay attention when you see news story about an earnings report for a company you own. It never pays to be in the dark.

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