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Decoding Corporate Earnings Reports

It's earnings season and that means, over the next several weeks, we will be deluged with the latest quarterly financial results from thousands of publicly traded companies. While the biggest, best known and most widely held stocks will get the most attention (and closest scrutiny), virtually every listed and traded stock in the developed world has to disclose how they did over the previous 90 days.

For this installment of Investing 101, we brought in Jim O'Shaughnessy, founder of O'Shaughnessy Asset Management and author of "What Works On Wall Street" to discuss three of the most important means of measuring these results. They say Wall Street is the ultimate "bottom line business" so that is where we begin.

The Bottom Line: "Net income is so important," O'Shaughnessy says "because it's really what the company has after everything is taken into consideration.'' Unfortunately, there are many, many stops along the way which is both a blessing and curse when you are evaluating the growth and profitability of a stock, as O'Shaughnessy says, "there's all sorts of ways to manipulate these numbers." And that's the rub.

Say for example that Nestron Incorporated sold off its international division during the quarter and booked a huge profit, which in turn, made the bottom line results look really strong, when in fact, the asset sale really had nothing to do with the day-to-day operation of the business. The same distortion would apply if the company had posted a large one-time loss too, which is why many investors and analysts feel a so-called "ex-items" number is a better measure of how things are going.

Companies know this and have gotten very creative at finding ways to ''dress up'' their numbers and put them in the best light. Another area to be mindful of is which number is the Wall Street consensus estimate based off of. If you're cheering strong net income, but traders are reacting poorly to an ex-items result, you're going to get hurt.

The Top Line: Since the top line, or sales/revenue comes first on the income statement, many investors prefer it, solely because it tends to be pristine. "You need to be careful," O'Shaughnessy warns, "because what investors tend to do is they tend to fall in love with companies where the revenues are skyrocketing."

That's a problem, he explains, because people don't pay attention to how much they are paying for that growth and end up paying a lot for every dollar of sales or earnings. Years of research and experience taught him that "what you're paying for something is more important than what the actual earnings or sales growth number is."

Guidance: The expectations game or the crystal ball is, arguably, even more important for investors than the top or bottom line.

"The reason many companies give guidance is they want analysts to make it their forecast for earnings," he says because they want to be as close to what the expectations are on Wall Street, and in a perfect world, beat them by a smidge. At the same time, he says companies that don't give guidance are "playing a much riskier game" as they are leaving analysts to their to own devices.