How to read companies' quarterly results

Companies have already published their quarterly results for the December 2009-ended quarter. These are the income statements which listed companies are required to publish at the end of each quarter.

An unexpected gain or loss will move their share prices either up or down, respectively. And as these prices move, it will provide a great opportunity for stock pickers.

Most of these movements will be based on headline numbers published in the income statement. Markets, as often noticed, would tend to miss in-between-the-line items in income statements. So, a fall or a gain in the share price of a company could also be an opportunity to buy cheap or sell high.

In deciding a share purchase, you look at whether earnings expectations support the market price. Among other factors, these expectations depend on the current earnings, which are presented on the company's income statement. Therefore, in order to make the right decision, the first step is to properly understand earnings statement.

Here, we take a look at a few items on the income statement that are often ignored, but are among the most important factors in shaping earnings expectations. . . .

Beginner's guide

The income statement, also called the earnings statement, lists down much revenue a company has generated during a period. The period could be either a year or a quarter. It also lists down all the expenses the company incurred to generate that revenue. These expenses are then deducted from the revenue to get profit.

There is no one unique way to present revenues and expenses on an income statement. Companies from different industries adopt different styles. However, you can get a general idea of the presentation by considering income statement as a multi-step process. Each step starts with a measure of profitability from which some specific expenses are deducted.

The difference that we get becomes another measure of profitability, which is also the beginning of the next step. This process is repeated until we reach the "net profit", which is widely called the "bottom line".

So at the top of the income statement is gross revenue or sales. It is the revenue earned by a company by selling its goods or services.

We call it 'gross' because at this stage no expenses have been deducted yet. From this, excise duty and the amount the company doesn't expect to recover from its customers is deducted. The balance that we get is the first measure of profitability, called net revenue or sales. . . .

You can find a few lines mentioned under the head 'operating expense'. These are the expenses associated with generating revenue. In a line, you will also find the mention of 'depreciation' expenses.

When a company buys an asset, which can be used over multiple years, it does not report the expense in a single year alone. The cost of buying that asset is spread over the useful (estimated) life of that asset. 'Depreciation' shown for a particular period is the cost allocated for that period.

Subtracting operating expense from net revenue gives operating income or profit. It is the profit that the company has generated from its core business operations. So, in an income statement, it is the most important measure of profitability.

Further down the income statement, loan repayment and tax expenses are deducted from the operating profit to reach the net profit.

It is called as the 'bottom line' because this is the profit available with the company for distribution to shareholders. Companies also mention earnings per share or EPS. It is the ratio of net profit to outstanding shares. . . .

Between the lines

The headline profit numbers can sometimes prevent you from looking at deeper issues within the company. Here are a few such items you need to look out for.

Other income

The key to using an income statement is to correctly forecast company's profits. You might be doing that by looking at current earnings and applying them to the future. However, you could be grossly wrong if you ignored 'other income' mentioned in a subtle way in a company's earnings statement.

Other income, as the name indicates, is the income generated by company from sources other than its core business operations.

It includes income such as interest income and earnings from selling company's investments. Mostly, this is an unpredictable earning and you should exclude it from your future earnings calculations.

Take the case of exploration and production company Hindustan Oil Exploration Company (HOEC). In the first quarter of fiscal year 2010 (Q1FY10), the size of HOEC's other income was around 70 per cent of its total income. In previous quarters too, company's 'other income' was significant as compared to its total income.

However, in just one quarter, the 'other income' dropped to Rs 90.14 lakh as compared to Rs 13.50 crore in previous quarter. So you would have been wrong if you had betted on its past "other income" to forecast its future earnings. . . .

Extraordinary items

These are expenses or earnings that are both unusual and infrequent in nature. One such expense is 'impairment charges'.

Consider Dr Reddy's Laboratories' annual result for FY09. It reported a loss of Rs 917 crore due to "impairment charges" on goodwill and intangible assets at Betapharm, the German firm it acquired in 2006. This means the present value of Betapharm's assets is less than the value at which it was acquired.

The company shows this loss as expense which reduced its profit. But this does not indicate Dr Reddy's profitability declined. This is a one-time expense. You will be mistaken if you discount company's future earnings by this amount. . . .

Forex gain or loss

This item can be noticed in the income statement of companies that have foreign operations. Companies usually hedge their foreign income from currency fluctuation.

However, wrong bets on currency movements can sometimes result in large forex gain or loss. It can also occur when companies borrow in foreign currency. Depreciation in rupee's value against dollar means a company would need extra rupees to repay dollar loans. This is not views positively by the market, and it pushes down the share price.

However, the downward movement in prices could also offer you an opportunity to buy cheap. You can buy such shares when you are confident that the company's fundamentals are strong and the forex losses are temporary.

One such opportunity was pharmaceutical major Aurobindo Pharma. It reported huge forex losses, which reduced its profits, in 2008 due to foreign loans it had taken earlier. Markets sentiments pulled down its share prices from the level of Rs 700 to Rs 200.

But during this period, company's core pharma business continued to do well. Soon, the forex losses reversed and the share prices rebounded.

Stay away from companies that make forex losses large enough to affect the company's dynamics. An apt example is healthcare company Wockhardt. In the first half of 2009, it made forex losses of Rs 500 crore. These losses forced the company to sell off some of its businesses. . . .

Incomparable statements

One way to measure a company's performance is to compare one quarter's earnings with earnings of corresponding quarter in the previous fiscal. We also call it year-on-year growth.

However, some events in the company can make this exercise misleading. An example is pharma company Zydus Wellness. In 2008, the company merged consumer product division of Cadila Healthcare with its operation.

Now if you normally calculate the y-o-y growth in Q2FY10 earnings of the company, it would turn out to be 275 per cent. However, it was a one-time impact. So whenever you find unusual growth, look back for meaningful comparison.

Diluted EPS

A company can sometimes issue financial instruments that can later be converted into common shares. As the number of shares increase, it might decrease or dilute EPS. A high dilution in EPS calls for caution.