If a stock falls, post-results, only because the quarterly numbers did not match ‘expectations’, it may be best to avoid selling the stock.
As we put the June earnings season behind us, one question that is likely to linger in investor minds is about how stock prices react to results announcements. Sometimes, a lot of hype is generated before the declaration of the results and the stock is on an upward march, only to be hammered once the numbers are out!
The numbers not being up to ‘expectations’ is often the reason cited for such events. If the numbers don’t meet street expectations, does it automatically mean that the company is not doing well and that you should sell that particular stock? Not necessarily. To understand a company’s performance, you must know how to read and evaluate quarterly numbers.
Trends in input costs: High costs of input can affect a company’s profit margins to a considerable extent and input costs (mostly commodity prices) can be cyclical as well as seasonal.
Therefore, price trends in a particular quarter may not sustain in the next one. For instance, airlines have been affected by the high cost of aviation turbine fuel last quarter, but if prices fall, that could improve profits next quarter. The high cost of steel has dented the profitability of automobile companies and any correction in steel prices can help in the next quarter.
Seasonal business: Some businesses are seasonal in nature, with much of the revenues or profits being made over one period of the year. Hotels register their peak performance in the winter season, when tourist arrivals are at a high. Cement sales and construction activity are usually down in the monsoon months.
Launch or project expenses: Some businesses may have to incur huge initial expenditure while launching a product, commencing a business or floating a project. This can also be on research and development cost or those associated with acquiring or merging entities. Though such expenses, in the short run, can affect profits, in the long run, they may aid the company’s growth. The investor should carefully evaluate if project-related expenditure is on account of delay in implementation or cost-overruns, which may be negative.
One-time expenditure: Employee VRS expenses, one-time settlement charges for any legal dispute, charges payable on account of statutory dues may drag down a quarter’s profits on a one-off basis, but may actually have positive implications for the long term. Corporates such as Century Textiles, Phoenix Mils, Bombay Dyeing have incurred high expenses on account of VRS in the past.
However, the resources such as land and building that were released as a result of the closure of units have resulted in windfall gains or opened up business opportunities for them.
Non recurring income: The sale of a division/asset or a stake in subsidiary company can provide a one-time boost to income in one quarter and artificially depress growth rates, if calculated on this base.
For instance, HDFC had booked a sizeable profit from sale of its stake in Intelnet BPO in the recent past. Such income is not likely to be of recurring nature and should not be considered for the purpose of stock evaluation.
Provisioning requirement: Provisions made towards losses on derivative contracts, decline in the price of debt securities, doubtful debts, etc may impact earnings one quarter, but may not necessarily sustain. The important point to note is that these provisions may be reversed in future in case there is any change in the asset price of security or recovery of debt.
Quarterly numbers is not the key parameter to judge a company. The same should be read along with the sustainability of earnings and general business conditions. A quarterly analysis should be used to find out if there is a systemic decline in the business or profitability. Only that is a case for an exit. If a stock falls, post-results, only because the quarterly numbers did not match “expectations”, it may be best to avoid selling the stock. Wealth maximisation requires you to stick with a business for the long term. This may require riding over short-term blips in stock prices and earnings as well.
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