Why Earnings May Be Deceiving You
Earnings, especially earnings per share (EPS), are the little darlings of Wall Street. It is something all the financial pundits drool over. When a company announces earnings that are greater than anticipated by analysts, the stock often soars into the stratosphere. This article will debunk the earnings myth and show you why earnings may be deceiving you.
Earnings are needed to keep a company running. But when companies don't allocate earnings properly, growth stalls. We'll explore why below.
What Are Earnings?
As obvious a word as earnings is, people often confuse what it means. Essentially, earnings are the profits of the company after all the costs are accounted for. It's also referred to as the bottom line, as that is where it appears on the income statement.
Most companies hope for a positive result for this bottom line, but that is not always the case.
Struggling companies will have a hard time keeping this number positive.
Conversely, companies with sound economics will turn a profit most quarters. These are the companies that get the attention of the financial press.
What About the Deception?
I did say that earnings are deceiving. However, before I get into why, let me just state that you still want to focus on companies that earn profits, thus have positive earnings. However, this should not be the end game. It's just the start.
Earnings are deceiving because they only reflect what has been earned on the current capital assets the company uses to make money. It doesn't help in any way towards expanding the business, unless a company uses the earnings to buy more or better assets.
In other words, suppose you had a lemonade stand, and you did everything you could to maximize the profits and minimize the costs. How is it possible for that lemonade stand to earn more profits than the maximum profits? The answer is it's impossible.
You may be thinking the earnings could be used to advertise and promote your lemonade stand. That is true. And, that may help to a certain point. If you get a flood of customers from your advertising, can your infrastructure and business operations handle these customers?
This may seem like a good problem to have, but the truth is it can be just as bad as having no customers. If customers wait too long on line to get your lemonade, they may not return. And they'll tell their friends of their negative experience. The exception to this is if the lemonade is spectacular, something they have never tasted before.
You may be earning a healthy return of say, 20% on that lemonade stand. But if you are looking to generate returns of 30% or more, you've got more to do.
Why This Is Important?
You probably have an intuition on where I'm going with this. Investors and Wall Street gurus, focus too much on just the earnings number. They hang on it like it's the Holy Grail. Dig deeper.
Learn what plans management has for the earnings. Are they going to buy more assets that will help it earn more money in the future? Or is the plan to buy back more shares of its stock, pay more dividends, or payout stock options?
The Deception Doesn't Stop There
Another deception with earnings that can trip up many an investor is earnings and cash flows are usually not the same thing.
Suppose you are a supplier of high-end shovels and you landed a great contract with Home Depot. Home Depot places an order for 10,000 shovels at $25 per piece. That's a $250,000 freaking order. Nice, right?
Great! Except Home Depot demands terms of 60 days before they pay! But they want the shovels delivered in ten days. Guess what happens on the tenth day when those shovels are delivered to Home Depot?
On your income statement, you'll need to record the $250,000 as sales. Then, you'll need to record the matching costs associated with selling those shovels.
Therefore, you wouldn't have the full $250,000 available even if Home Depot paid immediately. For the sake of this example, let's say after all your costs, your profit is recorded as $165,000.
This $165,000 may still seem like a nice chunk of change. However, you don't have it to spend. You have 60 - 10 days = 50 days left before Home Depot pays you on time.
Do you know how much money you would record in your cash account on the balance sheet? Zero! You haven't collected any cash. The amount that Home Depot agreed to pay is entered as an IOU known as receivables. You can't really pay your bills with your receivables!
There are some things you can do with receivables such as factor them. But that is a topic for another article.
Can't Expand a Business with Receivables
Getting back to the original deception, your company won't be able to use the $165,000 to expand your business until 50 days into the future. By then, you'll probably accumulate a bunch of costs (salaries, wear and tear for factors, more supplies for future production, etc.)
You may be thinking that the costs were already factored in, but you don't usually go through just one production cycle, and you may have other products that you sell that need cash to run properly. You probably will have other customers, too. The costs you accumulate are during these future production cycles.
If the costs for the next 50 days exceed what you'll receive from Home Depot (and other stores that you sell to) then you can quickly see how you won't have the capital needed to expand your business. This means you spend another 50 days without an increase in assets that will contribute to expanding your business.
Caveat: The above scenario assumes accrual accounting methods. If you were a small business owner, you probably could get away with cash accounting. This likely would change the scenario. However, since we're working with publicly traded companies for investment analysis purposes, most companies will be required to use accrual accounting.
What to Look For with Your Potential Investments
Even with the deceptions described, it is important to track earnings for the companies on your watch list or portfolio. But dig deeper and learn more about management's intentions of the money the company receives.
Specifically, what are management's plans for capital expenditures that have the potential to expand the business? You may need to dig into the financial statements Management Discussion & Analysis (MD&A). Also, look at previous years for the MD&A. Did management accomplish then what they said they would? Was the alternatives reasonable, if not?
Management may decide to buy back shares, which is normally a good event. However, if management is buying back shares to boost earnings, then this won't help the company much, if at all. When buying back these shares, often they'll buy them back after a run up in the price. This usually means the price management pays is inflated.
When Cash Is Not King
You hear that cash is king. Some companies like to hoard cash. That may seem like something good on the surface. But remember, it's the responsibility of management to maximize shareholder value. The returns on cash are low.
Some cash is needed for emergencies, of course. But beware companies who have too much of it. It's a judgment call as to what constitutes too much. However, you can compare competitors and take an average.
There are exceptions to this rule. If a company has plans to ramp up its asset purchases and wants to do so without incurring debt or losing equity, it's prudent for them to use the cash in this instance. However, they should alert investors via an earnings call or a press release, etc.
Does New CapEx Spending Make Sense?
Spending money on frivolous assets just to burn through cash is usually worse than hoarding the cash or paying a dividend. If management does not take care with its CapEx spending, it can cause financial difficulties for the company.
When you learn about the new spending, try to comprehend the reasons for it. This isn't an easy task and some spending can turn out much better than investors hoped. Seemingly good CapEx purchases may not work for host of reasons.
Acquiring assets is the cornerstone of running a company. The companies with the best assets that can be used to generate the highest profits come out ahead. This is an oversimplification, but it illustrates that proper allocation of new assets will fuel the growth of the firm.
Dividends
If a company cannot add value with its earnings (buy new assets for future earnings growth, etc.,) then the right course of action is to pay out a dividend. One challenge with doing this is if the company will need cash later on. Cutting a dividend is a sign by investors of weakness.
Conclusion
Get to know the companies you invest in. Treat these companies as if you are a partner in the business rather than just a piece of paper that hopefully goes up in value.
By becoming intimately familiar with the inner workings of your companies, you'll recognize when events are out of place. You can then call investor relations and ask what is going on.
