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Why Investors Must Look Past Reported Earnings

Ser Jing - Why Investors Must Look Past Reported Earnings (pic)The Price-Earnings (PE) ratio of a company’s shares is one of the most widely followed metrics used in the financial industry. Simply put, it tells us how much an investor is paying for each dollar of a company’s earnings.

Professional investors like John Neff and Shelby Davis have used the PE ratio to spectacular success in their investing careers. But, there are times when the PE ratio can fail in situations when the reported earnings aren’t reflective of business realities.

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Biosensors (SGX: B20) reported a profit of US$364.3m for its fiscal year ended 31 March 2012, which came up to an EPS of US$0.236. At a price of S$1.28 after the earnings release, the drug-eluting stent (a medical device used to unclog blocked arteries) manufacturer’s shares would have carried a PE of 4 based on those earnings.

Turns out, the profit of US$364.3m carried one-off exceptional items, the bulk of which comes from the gain on re-measurement of a joint-venture company that came up to US$279.6m. Those gains aren’t repeatable and are not a reflection of the earnings power of Biosensor’s normal operations, which basically involve the selling and licensing of their drug-eluting stents. If Biosensor’s results had the one-off items stripped away, profit would have been US$101m, equating to a PE of 15 instead.

That’s a big difference in terms of PE and might lead to erroneous conclusions on the part of an investor if it was based on a superficial assessment of the company’s valuation using reported earnings.

It’s quite common for companies to have one-off items in their earnings results and just last month, Singapore Post (SGX: S08) released its full-year results for the financial year ended 31 March 2013 and reported earnings of S$136.5m. Without the effects of one-off items, those earnings would have been S$141m. The difference might be small, but it’s still important for investors to note what the company has classified as ‘one-off’. In the mail-delivery company’s case, the bulk of the one-off items comes from a write-down of intellectual property rights amounting to S$5.8m.

One has to ask, is this actually a true ‘one-off’ or can it actually be recurring? SingPost has been aggressive in preparing itself for a digital generation and with such a transformation, it’s inevitable for the company to start acquiring more intangible assets such as software intellectual property rights. So, there’s always a chance of future write-downs if it were determined that such intangible assets have failed to deliver earnings power for the company. So, the actual reported net profit of S$136.5m might actually be a better representation of Singapore Post’s economic realities, a situation that’s in contrast of Biosensors’.

Foolish Bottom-Line

Companies might classify certain items as one-offs, but investors should be clear about whether the inclusions of these one-off items are an accurate reflection of economic realities for the business. And, that’s why it’s important to look past reported earnings for companies.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.