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Five Missteps to Avoid in Earnings Season

Scott Rothbort

Mistake 1: Relying Only on Headline Numbers

The run-up leading to the release of earnings is typically littered with analysts' expectations, which are disseminated to the investment world across a broad swath of the financial media.

We sit in anticipation of the earnings release, that one metric that seems to hold the financial world in its balance. When the release is expected to be made public, investors, analysts and the media repeatedly hit the refresh buttons on their Web browsers, attempting to be the first person to obtain that data. Headlines begin to appear on Bloomberg screens, across the bottom of the CNBC screen, in "Columnist Conversation" on RealMoney.com or on Google Finance.

With a headline, suddenly the world knows that XYZ Corp. earned 42 cents in the second quarter ended June 30. In after-hours markets , XYZ Corp. is getting whacked because the company was expected to earn 43 cents.

A few minutes pass, and more tidbits of information come across the screen, telling the world that "based on non-GAAP results, XYZ earned 44 cents." (In some circumstances, new data such as this does not appear in any headline, and you can only ascertain it from a buried spot in the press release or during the conference call.) Suddenly the geniuses that sold XYZ are buying it back (and then some).

The moral of the story is that headlines can be deceiving and you need to read the full text of the quarterly press release and listen carefully to the earnings call before rushing to judgment on the quality of the quarter (and the outlook for the future).

Mistake 2: Not Considering the Future

We are conditioned to focus on the company's most-recent results, which frequently zero in on EPS , revenues, margins or unit sales. So much energy is expended in trying to model-up (see earnings estimates ) these results that the future is often an afterthought. However, some of the basic tenets of security analysis dictate that the value of a company is the present value of its future stream of earnings and dividends .

All too often, a company reports a fine quarter, beating analysts ' consensus, but then a few minutes later confesses that the following quarter or year will not be all that it was cracked up to be and provides disappointing guidance.

The current results will send a false buy signal to the uniformed investor. What will really make the stock move will be the disappointing guidance. Be careful. Reserve your judgment on a stock until both the current results and the future guidance are in hand.

Mistake 3: Taking a Company's Guidance Out of Context

Once you know the importance of guidance, you need to take the concept one step further. You need to normalize guidance across companies.

Think of a two-dimensional model. One dimension is guidance -- management can either be conservative and low-ball guidance, or it can set the bar high and provide aggressive guidance. The second dimension is performance -- the company can either beat or miss consensus expectations. The next step is to observe how those two variables interact. Here is a simple guidance/performance matrix:

Thus, we have four outcomes:

• Fallen Angel: A fallen angel is a company that, despite setting low expectations, can no longer deliver satisfactory results, putting it in a dangerous decline. Investors might be seduced into catching these fallen angels, in the mistaken hope that the worst is in the rearview mirror. Pier 1 (PIR - Cramer's Take - Stockpickr) is a classic example of a fallen angel.
• Highflier: A highflier is a company that not only has high expectations but also always seems to outperform these expectations. Most investors make the mistake of not believing the highflier, thinking that this is the best it can get. As a result, they steer themselves away from these rapidly growing companies. Great examples of highfliers are Goldman Sachs (GS - Cramer's Take - Stockpickr) and Google (GOOG - Cramer's Take - Stockpickr).
• Under Promise Over Deliver (UPOD): UPOD companies set tepid prospects and consistently deliver results in excess of those expectations, fooling some investors into avoiding the companies. In most circumstances, Wall Street catches on, the UPOD has to provide more-realistic (usually aggressive) guidance, and the company turns into a highflier. The less likely route for the UPOD is that it fails to deliver and transforms into a fallen angel. The most notable UPOD in today's market is Apple (AAPL - Cramer's Take - Stockpickr).
• Over Promise Under Deliver (OPUD): OPUD companies paint rosy pictures but fail to deliver the goods to investors. OPUD is a very unstable condition because a chronic OPUD will have little or no credibility with investors. Thus, a company might OPUD once or twice but will ultimately become a fallen angel.

Mistake 4: Assuming Taxes Are Fixed

In "How to Read an Income Statement," I included a sample statement. Toward the bottom of the statement, above "net income," is a line for income taxes. Investors will often make the mistake of assuming that income tax rates are static or fixed. This could not be further from reality.

Income taxes vary from company to company, country to country and, yes, quarter to quarter. In fact, a small deviation in income tax rates can create a penny or more of EPS variance in either direction. Be sure that you normalize the impact of taxes when comparing results with other periods, guidance or consensus estimates.

Mistake 5: Not Accounting for Changes in Accounting

Accounting regulations are quite complex. From time to time, companies will adopt new accounting rules. This can cause a great deal of confusion among investors when reading quarterly earnings results and listening to conference calls. The implementation of new accounting rules can cause a relative discrepancy between the results of a current period and those of a comparable prior period.

A common investor mistake is to compare these two sets of results. So be on the lookout for reconciliations or pro-forma presentations to ensure that you have an apples-to-apples comparison when you analyze a company's quarter. A recent example of an accounting change that caused a great deal of anxiety was SFAS-123R (Accounting for Stock Based Compensation).

Earnings Homework

As you prepare for another blitzkrieg of earnings, here is some homework to keep you on your toes:

• Make sure that you read a company's entire earnings press release. Do not react to headline information before analyzing the company's quarter and its future prospects.
• Understand the company's guidance relative to the current results and expectations as well as management's history of providing conservative or aggressive outlooks.
• Understand the implications of recent accounting rule updates.