Four Tips for Understanding Earnings Reports

With Alcoa's AA earnings report on Monday, April 7, the latest quarterly earnings season has officially kicked off. (To listen to Alcoa's April 7 conference call, click here.)

So as an investor, how prepared are you for the ensuing cycle of company reports and conference calls?

Following up "Beginner's Guide to Earnings Calls," "Five Missteps to Avoid in Earning Season" and "Conference Calls: The Good, the Bad, the In-Between," this installment of The Finance Professor will focus on how to identify deceptive and confusing aspects of corporate earnings reports and conference calls.

1. Understand Time Frame Comparisons

When companies present data for comparative purposes in reports and on conference calls, they will refer to two different time relationships. The first one is a comparison of results for the current period to the same period a year ago. This is referred to as "year-on-year (or "YOY") growth or changes. So if a company is reporting fourth quarter results for 2007 ("4Q '07") the YOY growth would be relative to their "4Q '06" results.

The second time frame comparison relates back-to-back quarters. This is referred to as "sequential" or "linked" quarters. So sequential growth for 4Q '07 would be relative to 3Q '07.

The issue here is relevance. For some companies, YOY comparisons are applicable while for others, sequential evaluations are germane. How do we know which one to focus on? It all boils down to the type of industry or business that the company is engaged in.

For example, say we are listening to a conference call of a retailer such as Macy's M, which is reporting fourth quarter results. The fourth quarter spans the winter holiday shopping season of November through January. For Macy's, YOY comparisons are not just relevant, they're vital in digging into the company's results. Why? With Macy's (and most retailers), the fourth quarter is the largest contributor to the company's full-year results. So a comparison of 4Q to 3Q provides far less substance to the analysis of this retailer's results.

Recently, some homebuilders (like Toll Brothers TOL, Lennar LEN and Hovnanian HOV) tried to inject and emphasize sequential data points in the reporting of their quarterly results. This was an attempt to obfuscate the poor state of the housing market and provide an appearance of improvement, when little or no improvement was really evident.

On the other hand, a sequential growth figure can be an important metric for some companies and industries. This is especially true for non-seasonal and/or growth companies.

For example, Google GOOG is considered a fast-growing company. That said, analysts and investors are less focused on YOY growth, as sequential growth figures are more indicative of the velocity of growth of the company's business model. Hence, in Google's case, there is great interest in and speculation about the amount of "paid clicks" and "click-throughs" (important metrics for online advertisers) that Google may have generated in the first quarter of 2008 relative to that of the fourth quarter of 2007.

2. Get a Handle on Taxes

Taxes are recorded as "accruals" based on calculations by the company and its tax advisors. Sounds simple enough, but that's just the beginning.

Certain expenses may not be deductible for tax purposes. And some taxes are recurring, while others are one-time in nature. Companies may benefit from tax credits, tax loss carry forwards or settlements with taxing authorities. Plus, from time-to-time, tax authorities may audit a company's tax returns and require the payment of additional taxes that were not previously recorded by the company.

As you can see, there is nothing straightforward about corporate taxation.

When a company reports its results in a quarterly press release or during a conference call, you will be able to ascertain the "effective" tax rate that the company has recorded. Some companies will provide that information, while with others, you must perform that calculation yourself. Here's how: the effective tax rate equals income tax divided by income before taxes.