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Earnings Season 101

What Are Company Fundamentals?

The Securities and Exchange Commission (SEC) requires all companies that are publicly traded on a stock exchange to disclose their financial statements to the general public. The three stock exchanges in the US are the New York Stock Exchange (NYSE), the National Association of Securities Dealers Automated Quotes (NASDAQ), and the American Stock Exchange (AMEX). Together, these three exchanges currently list 4,768 of the stocks available for trading of the 9,787 total public US stock universe according to Portfolio123. The financial statements have three main sections that are required to adhere to the guidelines published by the Financial Accounting Standards Board (FASB).

  • Balance Sheet (BS) shows a snapshot at a specific point in time of all assets, liabilities, and shareholders equity.
  • Income Statement (IS) shows the change in these items over a specific period of time and groups them into revenue and expense categories. The FASB guidelines allow income smoothing to occur in an attempt to better match the timing of revenue with expenses.
  • Cash Flow Statement (CF)  is similar to what occurs on a bank statement in that it attempts to nullify any income smoothing presented on the IS and present what actually happened to the cash inflows and outflows over a specific period of time.

Apple Computer, Inc. (ticker symbol: AAPL) is not only a household name, but the largest publicly traded stock in the US based on market capitalization. This means that for any stock index - such as the S&P 500 - that is weighted based on market capitalization, AAPL has a stronger influence than say Microsoft Corp. Here are the recent financial statements for AAPL.

AAPL Balance Sheet (Source: Portfolio123)

AAPL Income Statement (Source: Portfolio123)

AAPL Cash Flow Statement (Source: Portfolio123)

The specific items listed on each of these three statements are the company fundamentals. They are the financial ingredients that determine if a company has a sustainable "recipe" with which to compete with their peers in the marketplace. These statements and their accompanying descriptive narrative are packaged into reports that can range from a dozen pages to hundreds of pages. There are typically few pictures and they make excellent bedtime reading! But for a skilled analyst, the documents disclose everything an informed investor would want to know about the internal workings of the company.

When Do The Fundamentals Change?

The SEC used to require that exchange listed companies to report on an annual basis within 90 days of the end of their fiscal year and on a quarterly basis within 45 days of the end of each fiscal quarter. Those requirements changed in 2002 for companies above a certain threshold (at least $75 million in value held by the general public and available for trading for at least 12 months) to 60 days and 35 days, respectively. This means that even if the fiscal year ends on December 31, it could be 60 days (or more) before the company discloses their progress in the form of an annual report (formally know as a Form 10-K). The chart below indicates that roughly 80% of the exchange listed companies have chosen December 31 as the end of their fiscal year. When weighting these dates by the market capitalization (one measure of company size), this date drops to a still significant 72%.

Recent data from Portfolio123 shows companies that posted their quarterly results in the first 11 months of calendar year 2019 (via Form 10-Q) did so with a weighted average lag of 31 days - within the newly required 35 day time span. Those that did not meet that deadline - as shown in the histogram below - are typically smaller companies who may not have the resources to staff a dedicated investor relations department. One thing to note about quarterly reports is that they are not required to be audited by independent accounting firms.

Looking again at data from Portfolio123, the small subset of firms that submit their annual report (Form 10-K) to the SEC website during the first 11 months of the year had a weighted average lag time of 40 days for calendar year 2019. This was well within the mandated 60-day threshold and almost all made it before the old 45-day limit that still applies to smaller listings. An important thing to note about Form 10-K is that it is required to be audited by an independent accounting firm who must state their opinion on whether the report represents a fair and accurate description of the financial business operations. For this reason, many analysts place much greater weight on the Form 10-K than Form 10-Q. Annual reports received via postal mail often include a glossy version of the 10-K with impressive photos fo investors viewing pleasure.

How Do Fundamentals Affect Stock Prices?

The release of company financial statements is often accompanied by a press release summarizing the key elements of the lengthy reports. Larger companies will also host an earnings conference call that closely follows the script from said press release. The statements, releases, and calls are all public domain and available to any interested investor (via the internet) at the same time. This helps to reduce the possibility of any impropriety such as insider trading and front-running. An analyst covering AAPL (and there are probably hundreds) updates their financial model when new information becomes available with the end result being what is called an intrinsic - or fair - value estimate. The chart shown below is the history of fair value changes for AAPL seen though the lens of Morningstar.

We can see when new information became available in the adjustments to the red line. Many analysts recognize the uncertainty surrounding these types of estimates and Morningstar makes this fairly obvious with their color scheme banding format. The black line on this chart indicates the monthly open, high, low, and close prices for AAPL. The volatility in the black line could be due to news flow for AAPL, industry forces, global influences, or simply changes in investor sentiment. From the Morningstar perspective, AAPL was modestly overvalued earlier this week.

We hope you can join us for future editions of our weekly blog. Please let us know what specific topics are most interesting to you. Thank you very much for your attention!

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