What to look for: Healthy Components in the Earnings Statement

Important attributes to look for in an earnings statement - HEALTY COMPONENTS: COMPARATIVE and TRENDS

Value investors look at individual lines in the earnings statement, not just the bottom line.

Improving gross margins - especially sustained improvement - signal strong business improvement.

Costs are under control, and the company is improving its market position.

Likewise, improving operating margins can show better cost control, greater efficiency, and rewards from earlier expansion cycles.

And value investors constantly compare companies in similar industries.

Gross margins of competing computer manufacturers, for instance, tell a lot about who has the

• best market position,
• production and delivery process, and
• business model.

Comparing the incomparable is an all-too-common investing pitfall. With earnings statements, this error takes three forms:

1. Earnings statements are not always broken down the same way.

• Although the bottom line is the bottom line, the intermediate steps may be different.
• One company's operating earnings may include marketing costs, while another's may not.
• Typically, statements from firms in the same industry are comparable, but not always.

2. Two companies that appear (and even are classified) in the same industry may have differences large enough to raise caution.

• Commercial and industrial suppliers, such as Honeywell, have consumer divisions, while consumer businesses, such as Procter & Gamble, have industrial divisions.
• Many businesses supply a mix of products in a mix of categories to a mix of customers.
• "Pure plays" in a business or industry are not always easy to find.
• The upshot: You must understand businesses before comparing them.

3. Numbers may include extraordinary items.

• Before comparing operating or net profit numbers, consider whether there have been write-offs for discontinued businesses or impaired assets that may be causing one-time distortions in the numbers.