Despite what you’ll often hear, the market is mostly pretty efficient: cheap stocks are generally cheap for a reason and expensive stocks are generally expensive for a reason. Opportunities do appear, but the really good ones are few and far between and you have to sift through a lot of information to find them. With reporting season ramping up, that information will soon be flowing thick and fast.
This process of sifting for opportunities one of the great skills of investing. Warren Buffett has famously invited anyone wanting to sell him a company to make a proposal – and says he’ll customarily give an indication as to possible interest within five minutes.
We can’t promise five minutes, but we are going to show you how to get the nuts and bolts out of a company’s result in 30 minutes. Even to this, though, we must add a qualifier: it’s important to have a decent understanding of the company’s business already. Getting to know a new business in just half an hour is impossible (unless perhaps you're Warren Buffett).
- Know what you’re expecting before the result is released.
- First review the three main financial statements.
- Use the presentation and notes to flesh out unusual items.
So here’s what to focus on in your half-hour. Table 1 provides a handy summary.
Investing newbies are sometimes surprised when a company announces a profit increase of 20% and the share price falls. It’s because market expectations matter. If investors were expecting a 25% lift in profit, a 20% increase would be disappointing.
|1. Review earnings forecasts||2|
|2. Think about what you expect||2|
|3. Review financial statements|
|3.1. Cash flow statement||3|
|3.2. Balance sheet||3|
|3.3. Income statement||3|
|4. Review presentation and notes to accounts||12|
|5. Consider outlook and future expectations||5|
So spend a few minutes considering the ‘consensus’ numbers beforehand. These are a kind of average of the brokers covering the stock (sometimes an average of the whole lot; sometimes they leave out the top and bottom numbers and average the rest).
Online and full-service brokers, and sites such as Yahoo Finance (head to the ‘analyst estimates’ tab for the specific company), usually provide forecast earnings per share. If you know what the market’s expecting, you’ll know whether the result is ‘good’ or ‘bad’. But watch out, because the company might be reporting its earnings on a different basis to the brokers' forecasts.
You might also spend a few minutes thinking about what else to expect in the financial statements. Shareholders in Carsales.com, for example, will expect to see cash paid out for stakes in iCar Asia and Webmotors Brazil in the 2013 financial year.
This reporting season, you should be aware of how companies with international operations report the effect of the falling Australian dollar. Most chose to report ‘constant currency’ results when the dollar was a headwind. Now the dollar is a tailwind, you should expect them to report in the same terms. Be aware that the dollar’s decline will inflate revenue and profit growth for companies with overseas businesses in 2013.
You’re now nearly five minutes in and already prepared for potential surprises. So what happens when the company reports its results to the ASX?
You’ll probably be tempted to head straight to the management presentation. It’s colourful and easier to understand than the ‘preliminary final report’ (the official title of the results document). Resist temptation and turn to the three main financial statements in the preliminary final report, each of which will account for another 3 minutes of your time.
Cash flow first
Perhaps surprisingly, the cash flow statement should be your first stop. Once familiar with this statement, it’s simple to understand. What’s more, it’s the statement that’s hardest for management to manipulate.
The cash flow statement helps you work out free cash flow. This is an important calculation, because it tells you how much of the cash generated by the company is available to shareholders. This statement also tells you how much cash has been spent on capital expenditure and paid out as dividends, how much has been allocated to debt repayment, and how much has been raised from the issue of new shares. All this information fleshes out the story.
|Head to the Ratio Analysis section of Investor’s College for more information on what ratios you should use in your analysis. The ‘top 5’ series is particularly useful because it looks at ratios relevant to each industry.|
Turn to the balance sheet next. Here’s where you calculate the net debt-to-equity ratio and other measures of financial health. Have these ratios improved or deteriorated, and why? What has happened to intangibles, and why? Is inventory piling up? Running your eye down the balance sheet, line by line, is a useful exercise.
Now to the income statement. It can be a surprisingly inscrutable financial statement, particularly when ‘significant items’ – usually negative ones such as writedowns – muddy the result. Still, you should eyeball revenues and costs line by line, then calculate gross margins and operating margins (also known as earnings before interest and tax or EBIT margins). If revenues are flat while costs are rising – which means margins are declining – you’ll want to investigate why.
The discipline of considering the three main financial statements first is important because your initial review will be unsullied by management commentary (or should that be ‘spin’?). With a bit of experience, reviewing these three statements should take only about ten minutes.
Of course, the financial statements usually raise more questions than they answer. So your next 12 minutes is all about investigating the issues you’ve identified. Review the management presentation, notes to the accounts and any other accompanying commentary. If you noticed something unusual in the financial statements, such as a significant drop in operating cash flow, management should explain it in the supporting documents (or in the notes to the accounts).
Your final few minutes should be spent on the company’s outlook statement (if provided). Is management bullish or bearish about the year ahead? Some management teams underpromise and overdeliver; others are too optimistic, too often.
Here’s where you should spend some time thinking about the company’s future. After all, it’s the company’s future cash flows that determine its valuation. A sober assessment of a business’s prospects – including an analysis of industry headwinds and tailwinds – is vital.
Before you know it, your 30 minutes is up. Your calculator and your brain have officially had a good workout. Just spare a thought for Intelligent Investor Share Advisor analysts, who have to accomplish these mental gymnastics several times a day during reporting season (they love it, of course).
With just half an hour of focused time, you’re well on your way to understanding the result. It’s easier than you might think, so why not give it a go this reporting season?