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A Fool’s guide to earnings season

With the interim reporting season gaining pace and blue chips including BHP Billiton (ASX: BHP) and Coca-Cola Amatil (ASX: CCA) due to report this week, it seems like a good time to review some investment points. Many investors use the price-to-earnings (PE) ratio as a method to value a company but like most things in investing the PE ratio should be handled with care. While fellow Fools know that the price of a stock means nothing until it is put into the context of value, accurately determining value requires a thorough analysis of the true earnings of a business.

Reporting season and results announcements are a good time to dig down and determine how accurate a picture the reported earnings really tell. If you are using an historic PE ratio, such as those reported in the newspapers, then it is important to adjust for any ‘one-offs’ as the official PE uses ‘reported earnings’.

Most investors prefer to use a forward-looking PE ratio, which requires making a judgement call and forecasting the next period (future) earnings. So for many investors, even more important than the release of financial results which look back on the period just past, are management’s outlook statement about future expectations.

While we all love to buy a bargain, which at times is signified by a low PE ratio, investors must always dig down and determine that the “E” in the PE ratio provides an accurate picture of not just the past but also the future! For example, while companies such as Boart Longyear (ASX: BLY) and Iluka Resources (ASX: ILU) may appear cheap on a low historic PE ratio, this is the result of the market forecasting a dramatic drop in earnings, which once reported will cause the PE to revert to a much higher multiple.

While most of the big surprises are already flagged to the market, due to the requirement that companies divulge whether their earnings will deviate from the previous corresponding period (pcp) by more than 15%, this requirement still leaves plenty of potential for companies to impress or disappoint.

Foolish takeaway

Reporting season can be a great time to discover new stocks and to assess how companies are handling the current business environment. It is also a time for investors to review their holdings and perhaps find opportunities to add to their portfolio.

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More reading

The Motley Fool’s purpose is to help the world invest, better. Click here now for your free subscription to Take Stock, 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.  This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Motley Fool contributor Tim McArthur doesn’t own any of the stocks mentioned.

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