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Earnings season is an exciting time for investors. Out of the thousands of quarterly reports you'll see in the coming weeks, hundreds of companies will announce surprising news that will create huge moves in stock prices.
But before you get overwhelmed by earnings hype, there's a key element you absolutely must remember in order to get through earnings season successfully. All the hard financial numbers you'll see among company SEC filings are history, and they don't necessarily mean a thing when it comes to assessing the future potential of a business if something has materially changed in the interim.
Why earnings season is important
Clearly, the fact that companies have to disclose their quarterly results gives investors useful information. Compared to some other countries throughout the world, U.S. disclosure requirements are quite broad-based, and if anything, they overwhelm beginning investors with the breadth and depth of information they include.
Moreover, being able to gauge the history of a business is an essential part of analyzing where it's most likely to go in the future. Typically, many successful businesses follow the same patterns of growth, starting out with extremely high growth rates that moderate as the business matures into a more stable and solid leader in its industry. Reviewing financial information lets you measure where a company is in its growth cycle and thereby make predictions on where it's headed both for the immediate future and in the years to come.
Don't get caught looking backward
But there are clear limits to working solely with backward-looking data. All too often, earnings reports will be obsolete even before they're released, because companies come out with game-changing events all the time. Consider these obvious examples:
- In each of the past two quarters, Apple's (NASDAQ: AAPL ) earnings have missed expectations. In the June quarter, the fact that the iPhone 5 was due out in the immediate future led many customers to put off purchasing soon-to-be-outdated Apple smartphones, and even the September quarter reflected only a few days' worth of iPhone sales and none of the sales of the since-released iPad Mini or other upgraded models within existing product lines. This quarter will be the first that assesses the true impact of these new products.
- Similarly, Microsoft (NASDAQ: MSFT ) missed expectations in October when it released quarterly results. Yet again, the software giant had huge releases during the past quarter that weren't reflected at all in its October results, including its Surface tablet and Windows 8 operating system. The company's coming release will be the first look at these new products, and they'll clearly have a huge impact on Microsoft's future prospects.
Even worse, some of this quarter's earnings reports may fail to include everything investors need to consider about companies' futures. Deep-discount retailers Dollar Tree (NASDAQ: DLTR ) and Dollar General (NYSE: DG ) , for instance, have benefited from the sluggish economy and the relative difficulty of low- and middle-income households to afford merchandise from other retailers, even handing Wal-Mart (NYSE: WMT ) some unexpected sales slumps in the process. But thanks to the failure of the federal government to extend payroll tax relief beyond the end of 2012, workers have seen an extra 2% of their paychecks disappear to pay higher Social Security taxes, leaving them with less disposable income. With the poor having less money to spend, deep-discount retailers face a major threat to their business, but since it didn't happen until Jan. 1, Dollar Tree and Dollar General will only have a month's worth of its impact included in their respective fiscal quarters.
Be careful out there
Fortunately, many companies issue forward guidance about their prospects not just for the current quarter but further into the future as well. It's that guidance that you should pay the most attention to, because it will help you put a company's past results into the proper context and tell you whether you should trust that a company's past fortunes will continue.
Earnings season promises to be long and full of surprises both positive and negative, so preparing yourself is an essential part of being an independent investor. Knowing what to focus on and what to ignore will help you avoid making mistakes in how you respond to earnings reports.
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