Look Beyond the Profits
Don't know whether to buy, sell or hold? Here are some questions you should ask before you decide how your stocks are doing.
By Elizabeth Frengel
March 16, 2005
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Wall Street's obsession with corporate earnings often roils the markets and sends your investments on a wild ride. That can leave individual investors wondering whether to buy, sell or hold.
Wall Street traders tend to focus on a few questions: Did a company meet or beat analysts' estimates? Are profits rising consistently? And the mother of all import: What's the outlook going forward? But you should ask some other questions before you decide how your stocks are doing.
Look behind the numbers
"Earnings are important, sure," says Daniel Bandi, manager of the Armada Small Cap Value fund. "But they're not the be-all and end-all when it comes to evaluating a company's financial health."
Plus, companies like to put their own spin on the profit numbers, excluding a one-time charge here or ignoring debt there (see "Games Wall Street Plays").
Before you hop on the bandwagon with a super-earner, find out how it arrived at its reported earnings. If the company had to invest heavily or take on a lot of debt to hit its profit target, proceed with caution. Big banks, for instance, often gobble up smaller competitors just to get the earnings boost. And sometimes the rapid expansion isn't manageable and doesn't make sense.
A stock is priced on what the company is expected to earn in the future. So if a company is accumulating debt too fast (what money managers refer to as "leveraging"), the growth may not be sustainable, Bandi says. In other words, a company may not be worth what the stock market says it's worth.
Temperature check
To see how leveraged the company is, start with its debt-to-equity ratio and compare the figure to those of its competitors. The lower the better, but some sectors, such as finance and manufacturing, tend to carry more debt by the nature of their business.
Another way to check up on a company's health is to look at its return on assets. (To find a company's debt-to-equity ratio or return on assets, enter the symbol at the top of any Kiplinger.com page and click "Go." Then click "Financials." You'll find debt-to-equity under "Financial Strength," and ROA under "Management Effectiveness.") Return on assets is a more honest gauge of management's effectiveness than return on equity because the return on equity can be inflated by a company's long-term debt.
Earnings and ROA should track each other. Southwest Airlines (LUV), for example, has a trailing-twelve-month ROA of 2.8%, while Delta Air Lines' (DAL) is -2.9% (since the company lost money last year). These recent figures are pretty much in line with the companies' earnings reports.
Revenues, or sales, are another important component of an earnings report. Revenues (with one-time gains excluded) and earnings should be moving in the same direction. Lower revenues and higher earnings means a slimmer profit margin, which may be unsustainable. Higher revenues and lower earnings means that income is being eroded by operating costs.
Cash is still key
When considering a stock for his fund. Bandi focuses most of his attention on cash flow. Unlike per-share profits, cash flow (essentially cash receipts minus cash payments) is difficult to manipulate. Look at the cash-flow line on a company's income statement and you'll get a pretty clear picture of how much cash came in the door in a particular quarter or year. "It matters, because it's what the company pays the bills with," he says.
One last thing to check if you already own a stock: Rather than just tossing the annual proxy statement, skim through it to find out where the CEO's bonus comes from. If the bonus is tied to profit growth, the CEO has incentive to do things like rack up debt or make unnecessary acquisitions just to plump up profits. That, says Bandi, is not going to be good for shareholders down the road.