Understanding Financial Reports - Part II

In Part I, I gave an overview of the basic statements in a set of financial reports, namely the Profit and Loss, Balance Sheet and Cash Flow. If Part I was the “theory”, then Part II is the “practice” - how we can use financial reports to make profitable trades. As I’ll show below, financial reports do get quite complicated. But no need to worry because I’ll also show how we can piggyback off professional analysts’ work to find the important figures. So let’s get going.

Financial Reports Do Get More Complicated

One of the major difficulties with looking at different companies is that there is no hard and fast rule to determine what the most important figures and statements are. Unfortunately, it really does depend on each individual company.

For example, it’s important for a rapidly growing, small company that they are generating positive cash flow (to pay employees, suppliers etc), so the cash flow statement takes on extra importance. But this is not such an issue for large blue chip companies, like Microsoft (MSFT) and Wal-Mart (WMT). For them, analysts want to see that their sales and profits are growing, so their Profit and Loss Statement is closely scrutinised. In this banking crisis, Balance Sheets have been important as banks try desperately to beef up their assets.

Going a step further, specific numbers in these statements are keenly followed for different companies. Apple’s (AAPL) iPod sales are closely watched. With Tesco (TESO), an increasing same-store sales figure is important. And it goes on and on. It is very difficult to get on top of all of the numbers. So let someone else do that work for you - simply follow the market expectations.

Market Expectations

The most crucial part to understand about analysing financial reports is that it’s all about what the market expects the figures to be. For the purposes of trading financial reports, how the company performed against expectations is much more important than the actual company performance.

For example, eBay (EBAY) announced a 2008 net profit of $2.24bn. That’s a pretty damn good profit figure. But it was worse than what the market had expected. As a result, eBay’s share price fell 12.61% that day. In contrast, UK house builder Barratt Developments (BDEV.L) reported a 2008 pretax loss of £592mln. But because that was better than what market analysts had expected, they “beat the market”, Barratt’s share price rose 13.27% that day.

Many providers give the market expectations for different companies. One of the best in my opinion is Business Week. As you can see in the image, the average Earnings Per Share expectation of nine analysts following Coca-Cola (KO) is $0.65 for Q1 2009. The earnings calendar in the Weekly Wrap will keep you up-to-date on when Coca-Cola and others will be releasing their next reports.

Earnings Whisper Number

Market expectations are crucial in setting a benchmark by which a company’s financial reports are measured. But they are set by the big investment banks and their high-powered analysts. For a further look into what’s expected of a company, you can check out their “earnings whisper number”. Basically the whisper number is a gut feeling among individual traders, like you and me, of what the company’s earnings will be.

As you, I and any other average Joes help set whisper numbers, they’re not the most scientific of figures. Often not much economic analysis goes into people’s picks; instead they are often what traders “feel” earnings are going to be. The number can be quite valuable if it significantly differs from the official consensus estimate. EarningsWhispers.com provides a whole raft of whisper numbers.

Tracking Analyst Expectations

Financial reports are only released two/four times a year, but that doesn’t mean that there are only two/four static market expectations a year. Instead, these expectations are changing all of the time. News affecting company’s prospects is released every single day. But it would be nearly impossible for amateur traders to stay completely on top of all of this. Luckily we don’t have to. Investment banks have analysts whose sole job is to be abreast of any new developments in their coverage universe, which can often be only one or two companies. These analysts will have spent hundreds of hours going through everything to come up with their expectations. Then they publish their findings for all of us traders to see. Saves us a hell of a lot of work. Yahoo! Finance has pretty comprehensive Analyst Opinion and Analyst Estimate sections.

When these analysts change their mind on a company, the share price does move. In the past two years, many companies have seen their earnings estimates repeatedly cut, which has fuelled the collapse in their share prices. My advice is to keep an eye on analyst expectations for a company that you are thinking about trading. They can be a pretty good leading indicator of where the share price is going to go.

Conclusion

Getting a comprehensive handle on financial reports is a time consuming task. But for the purposes of trading, it’s not that overly critical. A basic-to-intermediate knowledge of the key figures and what they mean will suffice.

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