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Investment behavior is based on predictions about the future behavior of the market and of individual stocks. Those predictions are based, in large part, on the past behavior of companies. Those that have shown profits are likely to do so again. In the United States, the Securities Exchange Commission requires publicly traded companies to file documents, called earnings reports, outlining their profits and losses. Corporations also release reports highlighting the numbers they feel are most relevant to the investors interested in the company and providing analysis.
Some investors just read earnings press releases, but these contain little information. An alternative to reading the press releases is to go to the source: the actual earnings report documents the company files with the Securities Exchange Commission from which the earnings report is prepared. Each quarter, the company must file a form 10-Q, and it must file a form 10-K annually. These filings include an income statement, the company’s balance sheet and cash flow statements, along with analysis of the company’s position and identification of its vulnerability to market changes.
When analyzing an earnings report, investors should be careful to separate the company’s own analysis from the numbers it includes. The report is important for the company because it shapes investors’ expectations about the firm’s future performance. To encourage investment, companies try to put as positive a spin as possible on the figures in the report; they are limited, however, by the Securities Exchange Commission’s strict rules on accurate reporting. Investors should try to focus on the company’s numbers rather than the report’s rhetoric.
Each earnings report has the same structure, prescribed by the Securities Exchange Commission. Part I gives financial information, and Part II gives other information, including legal information and analysis on the company’s position relative to the market. Investors should pay attention to the information in Part I, especially the company’s net income as compared to past performance, and the market risks to which the company is vulnerable, which are reported in Item 1A of Part II.
It is important that investors have an accurate impression of a company’s earnings so they can make informed decisions about the stock’s desirability. Past profits make future profits more likely. Earnings are also instrumental in figuring out the price to earnings ratio, or the P/E ratio. This is found by dividing the company’s market capitalization, or the total price of all its outstanding shares, by its annual earnings. Historically, the average P/E ratio has been about 15; significant deviations from that number are clues to investors that a stock is either undervalued or overvalued.