10 Common Financial Terms Every Newbie Needs to Know
By Socrates Alvarez (Investopedia)
Eanings per share? Cash equivalents? Guidance? For many beginners, tuning into CNBC or reading the average financial blog post can be a pretty alienating experience, especially when most of the content is inundated with technical lingo. While most news covers sports and politics in a largely intuitive language that caters to a wide audience, stock market news is typically delivered to more educated, affluent demographic that is assumed to be well-versed in investing jargon – even more so in updates reporting the quarterly successes of a publicly traded company.
In order to get a better understanding of what youread, we’ll briefly explore the terms you commonly encounter in market news – specifically when a company announces its earnings. This article will illustrate where you will see these words, what they mean, and what they pose for a company using excerpts from an earnings news report covering a fictional company, Hemlock Incorporated.
Hemlock Incorporated announced its fiscal 2013 Q2 results after the markets closed, reporting non-GAAP earnings per share of 67 cents, an increase of 17% from last quarter, coupled with a net income of $250 million, up from $235 million. Earnings guidance from Hemlock Incorporated fell within range, with EBITDA, Net Income from continuing operations, and free cash flow beyond the high-end of their respective guidance ranges.
Highlights from the second quarter of 2013 include:
. Cash and cash equivalents of $128 million.
. EBITDA increase of 19% from Q1.
. Free cash flow of $35 million, up from Q1’s $32.70.
. Total debt increased from $95 million to $100 million.
However, despite the 17% EPS gain, Hemlock Incorporated missed well below the Analyst earnings estimate of 71 cents. Coupled with Hemlock’s increasing total debt, some analysts are left questioning the company’s ability to service its debt moving forward.
3 Common Terms
Net income (NI) in its most basic definition refers to a company’s total earnings, or profit. Simply put, NI is the difference calculated when subtracting expenses from revenue. When a company’s NI increases, it’s normally a result of either revenue increasing or expenses being slashed. It goes without saying that an increase in NI is generally perceived as a positive thing and factors into a stock’s performance. Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA) compare to NI paints a rawer image of profitability. While some proponents of EBITDA argue that it’s a less complicated look at a company’s financial health, many critics state that it oversimplifies earnings, which can create misleading values and measurements of company profitability. As a new investor, it’s important to know the distinction between like measurements, as the market allows firms to advertise their numbers in ways not otherwise regulated.
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For instance, often companies will publicize their numbers using either GAAP or non-GAAP measures. GAAP, or Generally Accepted Accounting Principles, outlines rules and conventions for reporting financial information. Basically, GAAP is a means to standardize financial statements and ensure consistency in reporting. When a company publicizes their earnings and includes non-GAAP figures, it means they want to provide investors an arguably more accurate depiction of the company’s health, like removing one-time items to smooth out earnings. However, the further away a company deviates from GAAP standards, the more room is allocated for some creative accounting and manipulation (like in the case of EBITDA). When looking at a company publishing non-GAAP numbers, new investors should be careful of these pro-forma statements, as they may differ greatly than what GAAP deems acceptable.
Finally, EPS is one of the most common things brought up during an earnings announcement, and it provides investors insight into a company’s earnings health and often affects its stock price after an announcement. EPS is calculated by taking net income, subtracting the preferred dividends (for the sake of simplicity, let’s assume Hemlock Incorporated doesn’t offer dividends on preferred shares), and taking that difference and dividing it by the average number of outstanding shares. In the case of Hemlock, its current quarterly EPS is calculated by dividing its NI of $25 million by the company’s 37 million outstanding shares. When reported, EPS is typically compared up against EPS from either the previous quarter or year-after-year. As well, it is used in basic valuation calculations like the P/E Ratio.
Cash in Hand, Money in the Bank
Another things most news reports look at is how companies manage their money – specifically, how much they have in free cash flow, total debt, and what assets they have available in cash equivalents such as short-term government bonds that they can sell to settle debts. In Hemlock Inc’s announcement, free cash flow is increasing, meaning that after all expenses have been laid out in order to maintain the business’ continuing operations, the amount of cash it has on hand is growing. On Hemlock’s balance sheet, the company maintains cash and cash equivalents of $128 million, which can be converted into cash if required, especially in the event that their increasing total debt increases and their income takes a hit. When reading about a company’s quarterly success or failure, pay attention to these terms. How effectively a company handles the cash it possesses and how it pays down its debt are both indicators of their ability to grow and add value to their shareholders’ portfolios.
Plans and Expectations
Despite Hemlock has seen numbers jump in various areas over the past quarter, the fact that it missed analyst estimates doesn’t bode well for investor confidence. Earnings estimates are forecasted expectations of earnings or revenue based on projections, models and research into the company’s operations. Earnings estimates are most frequently published by financial analysts. When the company itself publishes its predicted earnings, it’s commonly seen or heard in the media as “guidance.”
Even if a company sees an increase in profitability, if the actual earnings fall below expected earnings, the market will see to it that the stock price adjusts to the new information (read: drop in value.) This is due to the fact that estimates are built into the current price of a stock. Thus, when investors hear how a company “missed expectations” in spite of higher revenues being reported, the market corrects the price of the stock accordingly.
The Bottom Line
Like anything else in life, learning how the financial markets work takes some time. Taking the easier approach and maintaining a level of ignorance can be dangerous, especially when it is the company’s prerogative to preserve investor confidence by using as many positive values as possible. Knowing what each term mean, why they are being used, and understanding how they affect stock price are just a few ways beginners can gain a better knowledge of the financial markets, as well as gain critical-thinking skills when it comes to financial news.
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