Market Edge: Understanding Earnings Reports

With the bulk of 2nd quarter earnings already being reported, the market is showing signs of life. The question is why are they so important, and how can the stock be going if their profits are down? First, it is important to recognize what we consider the three most important elements of analyzing an earnings report. The first is their bottom line profit, or earnings per share. Numerous analysts from major rating's agencies such as Thompson Reuters, or S&P, will set estimates on projected EPS months and even years in advance. They base their estimates on factors such as backlog of work, the companies own outlook, project revenues, and even leadership. An average EPS is then determined with a high and a low from all the analysts following that particular stock. When the actual report hits wall street, they will either "beat the street" or miss estimates. Although important, in the current market, EPS is not the key factor to follow. Because companies are taking drastic cost cutting measures such as cutting jobs, selling assets, or the worst one, issuing more common stock, the EPS can often be misleading. The most significant factors in today's market reports are the revenue and guidance. Most investors and hedge funds are looking for revenues to be strong, signifying that the work is still there. They know that with time the profits will come back if the business and cash flow is holding up. Take for example XL capital (a recent buy recommendation) who yesterday released reports showing a below estimate EPS but in-line revenues compared to forecasts. The stock closed up almost 2% AH despite their profits falling. The other aforementioned key aspect is that of the companies own guidance. Each company will issue their own guidance and project where they think they will be in the future. Because the stock market is priced close to 6 months ahead of current activity, investors are looking to guidance reports. With that being said, it is well known that most major players beat estimates here in the 2Q. There is a lot of optimism, yet also skepticism, that the economy could be bottoming. We will follow up with a series of articles on where we believe the market is headed and why, as well as what the effect 3Q reports may have on the market.