6 things to remember when looking at a company's earnings

REUTERS/ David Moir

It’s bloody out there in the markets. Real bloody. We’re off to the worst start in our lifetimes. But, earnings season has just begun, which means it can be much worse for individual stocks that report earnings short falls.

So I wanted to share with you a simple checklist to help guide you through the earnings reports and separate the good from the bad.

And I wanted to let you know that I’ll be appearing in an online exclusive on January 28. It’s called Earnings Exposed and will start at 4 p.m. (ET). (There will be a rebroadcast at 8 p.m. for anyone who can’t watch the first showing.) During this event, we’re going to discuss the underhanded, yet legal, accounting methods companies are using to fool investors into making poor investments.

I’ll be explaining how to spot these fakers, and even exposing some of them. You need to sign up to watch. You can do that here.

In the meantime, you’ll find this list helpful at beating these companies at their own game…

1. Ignore the headlines.

Websites such as Yahoo! will post articles that proclaim XYZ Company beat earnings expectations by $0.03 a share. And, believe it or not, investors react to that news without doing any more work. They forget that it’s important to actually read the press release and determine whether the sources of earnings are sustainable.

2. Find out if the revenue that companies report is of good quality.

Only thing you can check is their balance sheet: does the growth in revenue compare with the growth in receivables?  

If receivables are way up, it could indicate management offered customers incentives to buy a product today that they otherwise would’ve bought at a later date. Great now, but what about future earnings?

3. Look at profit margins and determine if the changes make sense.

Expanding margins aren’t a good thing if management is using accounting shenanigans to overstate the results. For example, a company may write off inventory in one period, and sell it in the next for a 100% profit margin boost!

4. Analyze the tax rate and share count.

Companies can use a variety of tax management strategies to get their tax rate down, effectively buying a penny per share of earnings. Stock buybacks do the same. So sometimes companies appear to beat earnings when they’re really just rounding up the reported earnings per share.

5. Track inventory growth on the balance sheet.

If inventory is rising and demand is starting to slow, for any reason, future margins are at risk. Unless inventory is rising ahead of a product launch or based on demand, watch out for it.

6. Check the cash flow.

For all a company might earn, it can’t spend earnings. It can only spend cash. Most companies don’t report their cash flow numbers in the earnings release. That means it’s important to check them in the SEC filing, which usually comes out within 45 days after the quarter. (Remember, cash is king.)

These are a few quick things you can do to check up on your holdings so you can spot trouble before the stock implodes and torpedoes your portfolio. Many of the warning signs are right there in plain sight. Don’t be the kind of investor that ignores them.

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