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Which Stocks Will Spring Earnings Shocks?

Some companies are more likely to deliver nasty earnings shocks than others. Tim Bennett looks at a number that can help to identify them.

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Killik Explains: Which Stocks Will Spring Earnings Shocks?

Transcript

Welcome to this Killik explains Fina's video this week. Is there a way to spot stocks at risk of earnings shocks easy to make it through the way that's quite useful because the last thing you want as an investor is no earnings surprise on the downside and a big stock selloff that catches you unawares. So that's the basis of what was all about now. So in a nutshell the problem is this profit loss accounts of a Paddon on a cruise or matching basis and it is not an accounting videos. Essentially what companies have to do when they put together a profit and loss accounts perfectly legally is book income that's been a good book. Costs have been incurred but those words are not the same as cash receipt cash paid. So you don't think a difference thanks to something called a Kroll's is the technical term between the income statement if you like the earnings number the company puts out the actual net cash generating. And the bottom line is. The fact that there's a difference. That leaves firms with scope to move profit around from one period to another. And as an investor that matters and I'll try to sell you wide just a moment. Now spotting it requires a bit of detective work. There is a number called a cruise right. There it is which is one way of spotting firms or being a bit aggressive with their accounting no chronic splaying and just a moment. And it tries to uncover stocks wet heavy use vehicles is going on.

There's a mismatch between income and cash flow and therefore in the future you might get a nasty shock. Why. Well how profits can be flattered. So let's take a look at it is not an accounting video per se. Just a quick snapshot. It's this very simple example let's imagine a firm is sitting down mapping out what profits look like over three years. So expected profits. The trend is not looking that great right. Declining expect profits a hundred year one 18 year to 50 year 3000 right Ehsanullah make shareholders happy and investors want to buy the stock. So what do we do if someone is you can basically I will. Looking ahead we can see some of the nasties and some things that need to be provisioned schools and things we should book in the year ones profit Moscow's costs. Now is going to be conservative be prudent investors don't like surprises. So let's assume those 50 million and Usal 50 of those then we think this is nuts. So in year one you can reduce the profit figure down to 50. Why would you want to do that. Well look a Whams next year too. We're not going to touch this line here. They cruise as it's called. We just leave that sort of bit of the profit tucked away not 50 until years three when we're going to release it back against profits. So we is actually we were a bit conservative in year one time I would need to Balda it back.

And can you see that if you were allowed to get away with that legally suddenly you can change a not very promising profits probably fall into a much better looking one in the hope maybe that investors won't necessarily spot one of your lies. Well it's pretty obvious isn't it. Investors should should be to see that that is different to that. But actually the way these things are book sometimes is less obvious than you might think. Enter the accrued ratio. So reason this matter is the online profit trend is down and you see that quite clearly through the use for growth. This can be managed I mean I suggested he can be reverse the steady aggressive it is going to be managed debates and investors might be easily duped that fall into the true level of profits. And if they all then when the company disappoints you are a problem because if you think about it back here. All right. This is a company that is not doing terribly well. Massive scope for an earnings shock because if investors are thinking well this is the pattern. And actually something goes wrong here and you get a nasty surprise.