INVESTING: Quarterly profit reports don't tell the whole story

November 5, 2007

Deciphering a company's quarterly earnings report often can be a challenge for an investor. Many companies, but not all, choose to announce their quarterly earnings either before the stock market opens or after it closes. The idea is that this gives investors time to digest the provided information and may be less disruptive to the stock's price than an intra-day announcement.

Many companies will "guide" investors during the three months leading up to their quarterly earnings release so there are not too many surprises when the actual numbers are disclosed. Proponents of earnings guidance believe it lessens stock price volatility, which some people view as beneficial.

The critics of earnings guidance believe it can contribute to a manipulation of accounting numbers. The chairman of Cisco Systems used to describe the company's earnings as "linear." Back in the day, his peppy conference calls led one to believe Cisco's business and earnings growth followed a smooth trajectory higher. Of course, that myth eventually was dispelled.

It is safe to say no business will grow at an uninterrupted pace in perpetuity. And therefore, managers need to do a better job of educating investors about the ups and downs of their business instead of trying to iron them out. Serious investors must read the 10-Q quarterly report a company files with the Securities and Exchange Commission after the public earnings announcement. This filing describes the company's results in much greater detail than does the press release on announcement day.

On earnings announcement day, it is not uncommon to see a stock price react in a way that seems opposite to the news delivered in the earnings report, befuddling even the seasoned investor. For example, sometimes a good earnings report is accompanied by a drop in stock price, or a poor earnings report is followed by the stock's zooming higher. The divergent reaction in the stock price frequently can be traced to the future outlook given by the company. In other words, the market is less concerned about what has recently transpired at a company than with what is potentially coming down the pike.

Investors also need to sort through the gains and losses taken in a quarter that are not related to the company's operations in that quarter. For example, a company may take a one-time restructuring charge for closing a division, or perhaps record an extraordinary gain for selling a building. Such items should not be ignored, since they factor into any long-term valuation of the business. And while it is true that one-time gains and losses will not be repeated in coming quarters, most companies will incur many of these "one-time" items over the span of years.

The quarterly earnings report presents shareholders with a checkpoint on the ongoing performance of a business. Long-term investors understand that it takes many quarterly earnings reports, stitched together over time as a mosaic, to provide the more useful long-term story of a company.

Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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