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5 things to look out for this earnings season

Earnings season is underway with many ASX listed companies such as Commonwealth Bank of Australia (ASX: CBA), Wesfarmers Ltd (ASX: WES) and SEEK Limited (ASX: SEK) reporting their full FY 2018 results.

As you read these reports and listen to the earnings calls, here are five things to look out for that I think might be useful:

Understanding the key earnings drivers 

It’s not enough to see if profits are up or down. What is perhaps more important is understanding why the results are that way and what are the main drivers behind them.

For example, an increase in profits that was driven by the sale of a company’s most profitable business unit might boost its results this year but those results may not be sustainable going forward.

How management chooses to allocate capital

One of the most important decisions a management team makes is deciding how they wish to spend their earnings and allocate capital to the most appropriate projects.

It’s important to understand what management are spending the company’s money on and the reasons behind those decisions.

A good management team can deliver strong performance even in mediocre businesses because of the impact of the decisions they make.

The technology industry today for example, has many companies such as Xero Limited (ASX: XRO) that are choosing to forego short term profits by spending more on developing their products so that they can gain market share.

A strengthening balance sheet

Each situation is different, but generally, it’s encouraging to see a company strengthening its financial position each year by generating more cash and keeping debt low or at acceptable levels.

This protects the company when unforseen disasters occur. It also buys the company time and options to pursue different strategies when its industry is disrupted (as is common these days).

Guidance / outlook

The stockmarket is constantly looking forward. What happened in the past is history. It’s important to understand management’s outlook and their guidance on future performance.

Hopefully the company has a management team with a strong track record of setting reasonable targets and consistently beating expectations.

Market reactions

Earnings seasons is often accompanied with wild positive and negative swings in share prices. Sometimes the market over reacts, sometimes it under reacts (in both directions).

That can create opportunities but just remember, as Warren Buffett’s mentor Ben Graham said, “the Market is there to serve you not to instruct you”.

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Motley Fool contributor Kevin Gandiya has no position in any of the stocks mentioned.

You can find Kevin on Twitter @KevinGandiya.

The Motley Fool Australia owns shares of and has recommended Wesfarmers Limited. The Motley Fool Australia owns shares of Xero. The Motley Fool Australia has recommended SEEK Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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