Understanding ‘earnings season’

With the hurricane that is August reporting season now underway, it’s a good time to cast an eye over your portfolio and consider the earnings results you expect to see.

While we will be hoping to see growth in earnings, for many companies that’s a tough task this year. Just ask Gerry Harvey at Harvey Norman (ASX: HVN) where sales are expected to be off 7% and profit before tax down a whopping 39%.

Investors should also be on the lookout this reporting season for management that dress up earnings. This is a proven way to identify companies that may experience troubles further down the road. As investors we want to own businesses that produce cash earnings. Good companies often have shareholder-orientated management and one way to tell quality management is by how they choose to report earnings results to shareholders.

This reporting season many companies will choose to highlight their EBITDA numbers. EBITDA is ‘earnings before interest, tax, depreciation and amortisation’. Warren Buffett’s business partner Charlie Munger has a word to describe what he thinks of EBITDA as a measure of earnings – however it’s too rude for our (Foolish) ears to repeat here! Other wags have called it ‘earnings before everything’.

Billabong (ASX: BBG) is one company that regularly highlights its EDITDA numbers in its releases and presentations. This practice can make the headline numbers look healthier than they really are. As shareholders in Billabong have found out in recent times – you can’t bank EBITDA!

Meanwhile, other companies will choose to focus shareholder attention on ‘underlying profit’. While this measure can often be sound, it is still important for investors to dig deeper. Particularly watch out for management who seem to make a regular practice of highlighting how well the company would have performed if it hadn’t been for this bit of bad luck or that never to be repeated (perhaps until next year) mistake.

Nufarm (ASX: NUF) management has for a number of years now presented their ‘underlying profit’ to smooth the effects of numerous one-off losses and material items it has racked up. I’ll be watching to see if they do the same again this year. At some point investors need to ask themselves if Nufarm is really as profitable as management would have them believe or if the so called ‘one-offs’ are actually more like regular expense items.

On the other hand, leading natural health brand Blackmores (ASX: BKL) consistently reports its NPAT (net profit after tax) results – and just look at the returns shareholders have enjoyed in this quality company with honest management. It’s been a similar experience for shareholders at 4WD accessories supplier ARB (ASX: ARP). Importantly, the free cash flows at Blackmores and ARB roughly mirror the reported net profit meaning that when these companies report they really are showing us the money.

Foolish Bottom Line

There are ‘headline’ earnings and then there are cash earnings. Management are notorious for presenting a headline number which makes a business look better than it really is. It’s up to us Fools to not be fooled!

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Motley Fool contributor Tim McArthur owns shares in Billabong and Nufarm.  The Motley Fool ‘s purpose is to help the world invest, better.  Take Stock  is The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead.  Click here now  to request your free subscription, whilst it’s still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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