Financial Statement Analysis: Learn The Best Tricks And Tips!
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Transcript of Financial Statement Analysis: Learn The Best Tricks And Tips!
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LEARN HOW TO READ FINANCIALS AND CALCULATE
IMPORTANT RATIOS!
Financial Statement Analysis
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Financial Statements Overview
Financial statements convey the results and financial position of a business
We use them to evaluate sales, profitability, cash flow, and other metrics
In the U.S. financial statements are prepared on a quarterly and annual basis
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Financial Statements Overview
Balance Sheet
Income Statement
Statement of Cash Flows
Statement of Stockholder’s Equity
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Balance Sheet
The Balance Sheet presents a Company’s assets, liabilities, and shareholder’s equity at a point in time
Assets represent future economic benefits i.e. office building, patents, or even inventory
Liabilities represent future economic sacrifices i.e. bank loans, accounts payable to suppliers
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Balance Sheet
Equity represents capital contributions to the business + cumulative retained profits (earnings)
Under the accounting equation:
Assets = Liabilities + Equity
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Balance Sheet
Current assets/current liabilities Assets/liabilities that will be consumed (or paid
off/settled) within the next year i.e. accounts receivable, inventory, or accounts
payable
Non-current assets/non-current liabilities Assets/liabilities that will not be consumed (or paid
off/settled) within the next year i.e. production equipment, long-term bank obligation
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Income Statement
The Income Statement summarizes the profit generating activities of a business
Most companies report a multiple-step income statement
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Income Statement
JC. Co. Income Statement For The Year Ended 12/31/16Revenue $100,000
Cost of goods sold ($50,000)Gross Profit $50,000
Operating expenses:Selling expenses ($10,000)
General and administrative ($10,000)Research & development ($5,000)
Operating Income $25,000Other income (expense)
Interest income $500Interest expense ($500)
Income before taxes $25,000Income tax expense ($10,000)
Net income $15,000
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Statement of Cash Flows
The Statement of Cash Flows shows how a company’s cash balance changed over a period
The statement classifies cash transactions into 3 categories:
Operating Activities
Investing Activities
Financing Activities
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Operating Activities
Operating activities represent cash inflows and outflows related to a Company’s main business activities
Inflows include: cash received from customers for the sale of goods/services, interest income, and dividends from investments
Outflows include: inventory, salaries/wages, other operating expenses, interest on debt, and income taxes
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Investing Activities
Investing activities include cash inflows/outflows related to the purchase and sale of non-current assets
Examples:
Purchase/sale of long-lived assets used in the business
Purchase/sale investments in stocks and bonds
Acquisition or disposition of businesses
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Financing Activities
Financing activities relate to the external financing of the Company (debt + equity)
Inflows: (1) shares issued to owners (2) borrowing money
Outflows: (1) dividends, (2) acquisition of shares, (3) repayment of debt principal
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Earnings-Per-Share (EPS)
Shares are units of ownership in a business that provide for an equal distribution of profit or dividends
All public companies have shares that are traded on stock exchanges
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Earnings-Per-Share (EPS)
Basic shares outstanding = the number of shares outstanding
Sometimes companies issue stock options or other equity awards to executives as compensation. This represents “dilution” to current shareholders
Diluted shares outstanding = the number of shares outstanding + any potential claims on common shares
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Earnings-Per-Share (EPS)
Earnings-Per-Share (EPS) = Net Income / Shares Outstanding Represents how much profit the Company generates
per share outstanding
Basic EPS = Net Income / Basic Shares Outstanding
Diluted EPS = Net Income / Diluted Shares Outstanding
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Profitability Analysis
Gross Margin = Gross Profit / Revenue
Operating Margin = Operating Profit / Revenue
Net Margin (Profit Margin) = Net Income / Revenue
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Profitability Analysis
Analysts typically compare ratio metrics relative to: (1) prior year results or (2) a peer company (i.e. a competitor)
A basis point represents 1/100th of a percent .01% = 1 basis point 1% = 100 basis points
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Activity/Turnover Analysis
Turnover ratios are important because they gauge a company’s ability to convert assets into cash
Asset Turnover = Sales / Average Total Assets
Asset Turnover shows how efficiently a business utilizes its assets to generate revenue!
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Activity/Turnover Analysis
Receivables Turnover Ratio = Sales / Average Accounts Receivable
Receivables Turnover measures the number of times during the period that the average accounts receivable balance is collected
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Activity/Turnover Analysis
Days Sales Outstanding (DSO) = # of days in period / Receivables Turnover Ratio
DSO represents the average collection period for a Company’s accounts receivables
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Activity/Turnover Analysis
Inventory Turnover = Cost of Goods Sold / Average Inventory
Inventory Turnover measures the number of times the average inventory balance is sold during a period
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Activity/Turnover Analysis
Days Sales of Inventory (DSI) = # of days in the period / Inventory Turnover Ratio
DSI measures the number of days it takes for a business to sell its inventory
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Activity/Turnover Analysis
Accounts Payable Turnover = Cost of Goods Sold / Average Accounts Payable
Accounts Payable Turnover measures how many times the average payable balance is paid during a period
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Activity/Turnover Analysis
Days Payable Outstanding (DPO) = # of days in the period / Payable Turnover Ratio
DPO measures how long it takes a business to pay its suppliers
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Activity/Turnover Analysis
Days Inventory Outstanding (DSI)
Days Sales Outstanding (DSO)
Days Payable Outstanding (DPO)
Cash Conversion Cycle = DSI + DSO - DPO
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Liquidity Ratio Analysis
Liquidity refers to the ease of ability in converting assets to cash.
Current Ratio = Current Assets / Current Liabilities The higher the current ratio, the more capable the
Company is of paying short-term obligations
Acid-Test Ratio (Quick Ratio) = Quick Assets / Current Liabilities
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Leverage Analysis
Leverage analysis is used to assess a company’s ability to repay its long-term debt
Interest Coverage Ratio = (Net Income + Interest Expense + Income Taxes) / (Interest Expense)
Interest Coverage measures how easily a business can pay interest on outstanding debt.
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Leverage Analysis
Debt to Equity Ratio = Debt / Equity
Debt to Equity ratio measures how much debt is used to finance assets relative to equity
All else equal, the higher the ratio, the higher the risk of bankruptcy
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Leverage Analysis
Debt-to-EBITDA ratio = Debt / EBITDA Very commonly used by credit agencies
EBITDA = earnings before interest, taxes, depreciation expense, and amortization expense
Different industries use leverage differently!
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Valuation Ratios
“Valuation is an art, not science”
In finance/accounting, valuation refers to the calculation of a security’s value
Valuation ratios are used to assess how “cheap” or “expensive” a company is
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Valuation Ratios
Price-to-Earnings Ratio (P/E Ratio) = Stock Price / EPS
P/E measures how much you are paying for a business relative to its earnings (profits)
Forward P/E ratio: Stock Price / Forecasted Future Earnings
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Valuation Ratios
Price-to-Cash Flow Ratio (P/CF) = Market Capitalization / Cash from Operating Activities
Market capitalization = share price * shares outstanding
This ratio measures how much you are paying for a business relative to its cash flow generation capability
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Valuation Ratios
Price/Sales Ratio (P/S): Market Capitalization / Sales
Measures how much you are paying for a company’s revenue
Typically used in start ups, high growth technology companies, or businesses without profits
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Valuation Ratios
Book Value (BV) represents the net assets of a business.
Book Value = Total Assets – Total Liabilities
BV per-share = Book Value / Diluted Share Count
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Valuation Ratios
Price-to-Book Value (P/B) = Share Price / Book Value per-share
P/B measures how much you are paying for the net assets of a business.
P/B is most appropriate for businesses with high tangible assets (i.e. a bank or insurance company) It is less appropriate for companies that have large
intangible assets (i.e. biotech/pharmaceuticals or technology companies)
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Valuation Ratios
Market Capitalization = Shares Outstanding x Share Price
Enterprise Value is a more comprehensive measure of a company’s value
Enterprise Value (EV) = Market Capitalization + Preferred Shares + Debt + Minority Interest - Cash
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Valuation Ratios
Enterprise Value-to-EBITDA (EV/EBITDA) = Enterprise Value / EBITDA
EV/EBITDA measures the multiple a potential acquirer would pay for a business
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How To Read Financial Statements
ALL public companies are required to file documents with the U.S. Securities and Exchange Commission (SEC) on a regular basis
A public company’s SEC filings are available to the public for FREE at:https://www.sec.gov/
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Key SEC Filings
10-K: An annual report filed with the SEC detailing a company’s financial performance
10-Q: A comprehensive quarterly report
8-K: A broad form utilized to inform shareholders of key events
DEF-14A: A Company’s annual Proxy statement
Form 4: A filing detailing executives’ buys/sales of shares
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10-K
Large companies ($700M+) must file their 10-K 60 days after their fiscal year ends
The 10-K is required reading for any serious investor!
Warren Buffett reportedly reads over 500 pages a day!
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10-K
A 10-K is a public company’s annual report with the SEC detailing its business performance
A 10-K IS NOT the same thing as a company’s Annual Report to Shareholders!
“All else being equal, invest in the company with the fewest color photographs in the annual report.”—Peter Lynch
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10-K Reading Tips
Don’t read it all in one sitting
Take many breaks!
The best way to read a 10-K is side-by-side with the prior year filing
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10-K: Business Section
The Business Section describes the ‘who’ and ‘what’ of the company
The business section typically describes the company’s products/services, its operating segments, competition, goals, employees, and market dynamics
It may also include recent events, regulation, labor issues, or potential lawsuits
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10-K: Risk Factors Section
The Risk Factors section describes key risks the Company faces i.e. employee strikes, dependence on a customer,
increased industry competition
Risk factors are often drafted by lawyers so the language can be ‘boilerplate’
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10-K Risk Factors Section
Key risk factors to watch out for:
Changes in competition Customer concentration (large customers) New/pending regulation Any important lawsuits Commentary about debt levels Dependence on certain products Dependence on certain suppliers or manufacturers
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10-K: Unresolved Staff Comments
This section requires companies to explain comments it received from SEC staff on previously filed reports that have not been resolved after an extended period of time
Any comments should be taken as a red flag!
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10-K: Properties
This section discloses information about a company’s significant properties
i.e. headquarters, manufacturing plants, store base, square footage, etc.
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10-K: Legal Proceedings
This section describes all of the Company’s important legal proceedings
The language may be boilerplate, but can identify key risks to watch out for!
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10-K: Item 5
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity
Item 5 essentially summarizes information about the company’s shares i.e. share price highs/lows, volume, dividends, and
share repurchases
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10:K Selected Financial Data
The selected financial data section provides financial information about a company for the past 5 years.
Most companies will disclose important income statement and balance sheet data, along with other key performance metrics
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10-K: MD&A (Highlights + Strategy)
Management’s Discussion of Analysis of Financial Condition and Results of Operations
The MD&A section typically begins with a discussion of highlights from the most recent year and the company’s strategy
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10-K: MD&A (Results Discussion)
The MD&A will include certain financial metrics over the past 3 years
The Company will also discuss income statement results over the past 3 years on a ‘line-by-line’ basis
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10K: MD&A (Results Discussion)
MD&A commentary varies, but typically includes:
why revenue increased/decreased
why profit increased/decreased
any one-time expenses
discussion on taxes
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10-K: MD&A (Liquidity & Capital Resources)
The next section of the MD&A focuses on ‘liquidity and capital resources
Here, the company discusses the significant sources and uses of cash This will include a discussion of (1) cash from operating
activities, (2) cash from investing activities, and (3) cash from financing activities
The final section of liquidity and capital resources discusses the company’s available credit resources
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10-K: MD&A (Contractual Obligations)
Under “Contractual Obligations”, the company will list a timeline of its obligations
These obligations may include: Debt, purchase obligations, and leases among others
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10-K: MD&A (Critical Accounting Policies)
At the end of every MD&A section, the company will discuss its critical accounting policies
These policies typically include: Revenue recognition Inventory valuation Impairment analysis Taxes
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10-K: Item 7A
Quantitative and Qualitative Disclosures about Market Risk
The SEC requires the company to discuss market risks such as: Interest rates Foreign currency Commodity prices
The company may also discuss how it mitigates these risks
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10-K: Financial Statements
Item 8 is the part of the 10-K that discloses the company’s financial statements
Item 8 also includes the auditor opinion and financial footnotes
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10-K: Financial Statements
All public companies must have an auditor Most select the “Big 4”—EY, PwC, Deloitte, KPMG
In the 10-K, company’s must release their independent auditor’s opinion
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10-K: Financial Statements
The audit report will contain the auditor’s opinion about the fairness of the financials presented and opinion the company’s internal control
Internal control represents the processes put in place to ensure integrity of accounting and financial information presented
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10-K: Financial Statements
Most companies receive an “unqualified opinion” on their audit
It is important to watch out for internal control weaknesses!
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10-K: Financial Statements
Balance Sheet for the past 2 years
Income Statement for the past 3 years
Statement of stockholder’s equity for the past 3 years
Statement of Cash Flows for the past 3 years
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10-K: Footnotes
The footnotes are presented after the financial statements and include a variety of details about the company’s accounts and policies
Footnotes are often the most important part of the financials to read!
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10-K: Footnotes
Key sections to read:
Revenue recognition
Accounts receivable
Inventory
PP&E
Debt
Acquisitions
Taxes
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10-K: Footnotes
Other important footnote disclosures:
Segment Reporting
Geographic information
Remember: reading the footnotes is incredibly important!
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10-Q: Quarterly Report
Large companies ($700M+) must file their 10-Q 40 days after the end of the quarter
A quarterly report is an abbreviated filing with the SEC detailing financial results from the quarter
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10-Q: Financial Statements
The financial statements are presented first
Footnotes are presented after the financial statements
The 10-Q is much more abbreviated than the 10-K and contains fewer disclosures
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10-Q: MD&A
The 10-Q also contains a “Management’s Discussion and Analysis” section
The MD&A starts with an overview of recent financial performance before discussing detailed performance
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8-K: Current Report
Form 8-K is the “current report” public companies must file with the SEC to announce major events shareholders should know about
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8-K: Current Report
A company should issue an 8-K for:
Acquiring another business
Asset sales
Quarterly results
Issuing debt and/or equity
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8-K: Current Report
A company should issue an 8-K for:
Restructuring plans
Change in accountants
Senior officer changes
Director elections/departures
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DEF-14A: Proxy Statement
All public companies need to file a proxy statement (DEF-14A) ahead of the annual shareholder’s meeting
Key disclosures include: voting procedure, background about directors and management, and compensation
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DEF-14A Proxy Statement
Notice of Annual Meeting of Shareholders
Details the who, what, where, and when of the meeting
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DEF-14A: Proxy Statement
Solicitation of the proxy: details what is being voted on and the board’s recommendation
Election of Directors Will include a background of each director
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DEF-14A: Proxy Statement
Board Committees:
Audit Committee
Nominating Committee
Compensation Committee
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DEF-14A: Beneficial Ownership
All proxy statements include:
a section disclosing significant (5%+) shareholders
Directors’ and Officers’ beneficial ownership
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DEF-14A: Director Compensation
As analysts, we want to know how much and how directors are being compensated
Directors are typically paid through a combination of retainer (cash) and equity
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DEF-14A: Executive Compensation
Executive compensation is the most important part of the proxy statement!
A company typically discusses: Compensation philosophy Role of the Compensation Committee Elements of compensation
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DEF-14A: Executive Compensation
Elements of Executive Compensation: Base Salary Cash Bonus Equity (options, RSUs, performance-based shares,
etc.) Others/perquisites
Summary Compensation Table
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Form 4
All directors, officers, and 10%+ shareholders must file documents (the Form 4) for changes in share holdings
A Form 4 MUST be filed before the end of the second business day following a change in ownership
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Form 4: Codes
P: Open market or private purchase of shares
S: Open market or private sale of shares
A: grant, award, or other acquisition of shares from the company
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Form 4: Codes
D: Sale or transfer of shares back to the company
F: Payment of exercise price or tax liability using portion of securities received from the company
M: Exercise or conversion of security received from the company
G: Gift (i.e. donation) of securities by the insider
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Form 4: Insider Buying / Selling
How many insiders are buying/selling?
Were the purchases/sales significant?
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Conference Calls (CCs)
Conference Calls are used my almost all public companies to report quarterly results
CCs are typically scheduled in advance via press release
Many CCs are also accompanied with presentations
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Conference Calls (CCs)
Conference Calls may also be held for:
Acquisitions/mergers/dispositions
Monthly sales calls
Significant corporate events
Many others
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Quarterly Results Overview
Public companies in the U.S. report results on a quarterly basis
Companies typically set reporting dates in advance
Keep an eye out for the 8-K or press release!
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Guidance
Some (but not all) companies provide guidance
Companies may provide guidance on: Revenue Margins Profit Store openings/closings Capital expenditures …and much more!
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Guidance
Guidance is not required by SEC reporting standards–it is entirely voluntary
Stocks can trade off guidance so pay attention!
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Key Performance Indicators (KPIs)
As analysts, we must identify a company’s key performance indicators
KPIs are typically disclosed and discussed in earnings releases, conference calls, and the MD&A section of reports
Some industries have very specific KPIs
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