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Spotting strong profits
This article appeared in the August 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
What to look for in those six-monthly company reports.
By Owen Richards, AIA
Every listed company has to publicly announce its profits half-yearly to meet ASX rules, within two months of the accounting cut-off date. This means the yearly profit reporting season for most companies is between July 1 and August 31. The half-yearly, or interim, reporting season is generally the corresponding six-monthly period following.
(Editor's note: Don't miss the Australian Investors' Association annual conference in September in Sydney. It features presentations from some of the market's top investors and provides important insights for long-term share investors.)
Profit is simply the difference between the aggregated revenues and aggregated expenses of a company for the full year or half year. Profit can also be called earnings, net income, the bottom line or even surplus. It is essentially a measure of how much money the company makes.
Allocation of profits
Profit can either be reinvested in the business to fund future growth (called retained earnings), or paid to shareholders as a dividend. Many companies retain a portion of their earnings and pay the remainder in dividends. The rule-of-thumb is for 50 to 60 per cent of after-tax profits to be paid as dividends, but this varies widely across companies at the board's discretion.
A dividend is allocated as a fixed amount per share and shareholders receive it as cash. Retained earnings are shown in the shareholder equity section of the company's balance sheet. Public companies usually pay dividends twice-yearly on a fixed schedule, but may declare a special dividend at any time.
Insights into performance
The two main reporting seasons (in February and August) are the most important times of the year to analyse company performances. It gives analysts and investors detailed insights into how companies are performing, individually and compared to other companies. It is essential information that the market uses to value companies and determine share prices. The overall results during reporting the season can lead to positive or negative market sentiment that will continue into the months ahead.
It is usual to see share price movements when companies report. It is not necessarily the actual earnings figures that causes this, but more the difference between the expected and actual results. This difference is typically known as an earnings surprise, because it was unexpected.
The expected earnings are based on a consensus earnings estimate, which is normally an average or median of all the forecasts from individual analysts tracking a particular company. Generally, analysts give a consensus for a company's earnings per share and revenue. The size of the company and the number of analysts covering it determines the size of the estimation pool.
If actual results differ significantly from consensus expectations, the share price will adjust accordingly. For example, if a company reports a 20 per cent increase in profits but was expected to announce 30 per cent, the share price will probably fall significantly. Generally, the profits announced will be close to what was expected, but some announcements will exceed expectations (surprise to the upside) while others will surprise to the downside.
Sometimes it appears as if the company has met expectations but the price still slumps. This usually relates to the considered quality of the profit figure. If the profit was made on falling revenues, perhaps it was achieved by action that is not indicative of future growth.
However, under our system of continuous disclosure, a company must immediately inform ASX (and the market) of anything that "a reasonable person would expect to have a material effect on the price or value" of the company's securities. This mitigates against too many surprises.
Another part of the continuous disclosure system is the issuing of profit guidance by companies, which state whether their anticipated profit for the next reporting period is likely to be higher or lower than previously announced, and for what reasons. Profit guidance can be provided at any time, inside or outside of the reporting season.
Guidance that differs greatly from previous advice can have a big impact on the share price. The earnings release is already old news as it represents the half-year that has already past. Analysts and investors are more interested in what the company is doing now and what it might do in the future. If the guidance is not encouraging, the share price will probably fall.
Analysts also look at the quality of the guidance, as this is a better gauge of future performance. The company's earnings need to be repeatable. The sale of assets is not helpful to future growth as the company cannot sell the assets twice. Sales growth and cost-cutting are better indicators of sustaining earnings.
Earnings that are controllable are important. Exchange rate windfalls, inflation effects or a cheaper price of inputs (for example, falling fuel prices) are not under the company's control. Finally, revenue must be bankable: companies that generate revenue but not cash create big uncertainties and this lower earnings quality.
Earnings per share
An accounting mechanism is required to enable the profits of different companies to be compared one with another, by reducing each to a common basis. An earnings per share (EPS) figure is calculated, so a company can be compared to its competitors, an index or the market.
The EPS is determined by dividing the net profit attributable to shareholders by the average number of shares on issue during the period. Sometimes EPS is stated as being on a fully diluted basis, which takes into account any extra shares that may be issued in the future, usually the exercise of executive share options.
Although EPS can be a key measure of company performance, it is unwise to use it in isolation. Accounting practices vary between companies, and profits and the number of shares can be tweaked. Slight changes to depreciation, the inclusion of property profits, capitalising interest, buying-in shares and different ways to treat dilution, can all influence the EPS figure.
Evaluating EPS quality
The EPS quality can be assessed by comparing operating cash flow per share to reported EPS. This is simply operating cash flow divided by the number of shares used to calculate EPS. Investors can rely on operating cash flow as "cash is king". A figure that is greater than the reported EPS means the earnings are of high quality, while a figure less than the reported EPS might be poor-quality earnings.
A company can show positive earnings on its income statement while also carrying a negative cash flow. It will probably have to borrow money to keep operating and this eventually will have to be repaid. A negative cash flow can also indicate likely operating problems, as either inventory is not selling or receivables are not being collected.
However, noting the trends in reported EPS is also important. The negative cash flow may have occurred for good reasons. Some industries have negative operating cash flows because of cyclical causes or the company needs to invest in R&D, marketing or IT systems. In these cases, the company may well be sacrificing near-term profitability for longer-term growth.
About the author
Owen Richards has been a trader for some years and is a member of the Australian Investors' Association, previous editor of its Equities Bulletin and a contributor to local and overseas trading magazines. The AIA is an independent, non-profit organisation aimed at helping its members become more successful long-term investors. It is renowned for its annual Investors Conference and the next will held from September 1-3 at the Sofitel Sydney Wentworth Hotel.
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