Five Missteps to Avoid in Earnings Season

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:

	Conservative Guidance	Aggressive Guidance
Miss	Fallen Angel	OPUD
Beat	UPOD	Highflier

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 Quote) 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 Quote) and Google (GOOG Quote).
• 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 Quote).
• 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.