Should Investors Pivot if EPS Goes Red? It Depends

Every quarter, public companies are required to report their financial performance to the Securities and Exchange Commission (SEC). A typical earnings report includes at least three main financial statements: income statement, balance sheet, and cash flow statement.

While earnings reports include a lot of helpful information, investors generally focus on earnings per share, or EPS.

Though no single number can tell the whole financial story of a company, EPS is considered one of the most important because it shows how profitable a company is. It's calculated by taking the company's net income and dividing it by the number of outstanding shares.

The income statement is basically a line-by-line summary of how much a company earned over a period of time.

It begins with a top-line report of the company's revenue from selling goods and services.

Then, lower in the report, it subtracts all costs associated with running the business.

These costs include operating expenses like raw materials and wages, interest expense—or how much the company pays in interest for borrowed money—and asset depreciation.

After subtracting all the expenses, the income statement reports the bottom-line earnings. This is how much the company actually earned or lost during a period.

If a company reports a quarterly loss, it means its EPS was negative. This isn't as simple as it sounds, however.

U.S. company earnings can be calculated in terms of GAAP or on an "adjusted" basis. Adjusted earnings remove unusual events from a quarter. These one-time events could reflect a large single expense like restructuring, an acquisition, a tax charge, or new facility construction.

Wall Street tends to focus on adjusted earnings, but investors should consider GAAP as well, which reveals a complete picture of a single quarter, including blemishes. GAAP earnings can sometimes be negative even if adjusted earnings are positive.

Keep in mind that adjusted numbers can make a difficult situation look more palatable. And GAAP might truly represent a one-time hitch that will eventually be overcome.

When a company reports an unexpected loss, that should raise eyebrows. Perhaps it's the first loss after many quarters of profitability. Or it may be part of a trend that's worsened over time.

"The trajectory of both the top line and bottom line are important considerations for investors, especially in relation to expectations from the company's management and the analyst community," Peterson said.

Researching previous quarterly reports helps provide a big-picture perspective. Did the company—and its covering analysts—anticipate this quarterly loss, or did it surprise? Did previous reports warn investors of issues ahead?

Next, listen to or read the transcript of the quarterly earnings call, which is usually available on the investor page of a company's site. Analysts often ask pointed questions on these calls, sometimes prompting company officials to provide answers that fill gaps in press materials that often paint a positive picture.

Finally, it's helpful to check analyst reports for Wall Street's perspective.

After evaluating the company's financial results, management commentary, and analyst reactions, investors can begin assessing whether the loss appears temporary or indicative of deeper problems.

Reasons to consider investing or keeping an investment when EPS turns negative:

• Any company can have a bad quarter. In some cases, it may come suddenly due to a product issue or something the company had no control over, such as an oil shock. A company posting a single negative quarter after many years of positive earnings isn't necessarily one to avoid, as long as management can explain why the loss occurred and how it plans to fix things.
• A company that reports a loss narrower than analysts expected or has a history of losses narrower than expectations could be improving, fundamentally, even if it's still unprofitable, Peterson noted.
• Certain industries can make companies more prone to negative results. For instance, pharmaceutical, mining, and energy companies are often subject to surprises, like the U.S. Food and Drug Administration demanding a product recall, a rise in interest rates that decreases metals prices, or a sudden drop in oil.
• Investors in companies involved in such industries might need to wear harder hats and be prepared for earnings that fluctuate more per quarter and per year than those of companies in steadier parts of the business world.
• The size of a company can mean it's more prone to losing quarters. This can include small biotech firms spending heavily to research a drug or small-cap firms with a developing product that one day could take market share from competitors. Earnings losses accompanied by steady revenue growth sometimes—but not always—give the company a fighting chance to reach a place where it can operate profitably, perhaps after making heavy investments and developing well-known and respected products. This is where investors need to be patient but not gullible. Many companies may make investors think they're just around the corner from profitability, but that's not always the case.
• If management has been around awhile and has successfully guided the company through past troubled periods, it might be worth trusting them to do so again. Sometimes, a company replaces old management and puts in fresh faces. When a new team comes on board, investors may opt to give them enough time to prove their mettle.
• The pace of earnings losses can be important. If the company has a history of narrowing losses and seems to be edging toward profitability, that can be a point in its favor. However, consider checking past reports to see if management provided guidance on when to expect profits.

Reasons to avoid companies with negative earnings:

• If losses started several quarters ago and appear to be steepening rather than improving, that's sometimes a flashing red light.
• If the company runs into a problem that seems long-range and expensive to fix, it may be a larger concern. Issues like these involve long periods of regulatory uncertainty, negative headline potential, and management upheavals that can keep earnings either negative or below par for years. Of course, every issue is different, but a company with a history of running afoul of regulators is possibly a poor bet. Lawsuits accompanying such controversies, not to mention fixing the underlying problem, can cost billions, while negative headlines often repel other investors from the stock.
• A still-profitable company with falling revenue and weak guidance can raise investor concerns. Such a firm may be struggling to keep market share amid changing tastes or looming competition. Consecutive quarters of guidance cuts or reduced sales forecasts are rare and worth noting.
• Some companies spend too much. It might be justified in a firm trying to grow through major acquisitions, product developments, or hiring. Still, if spending shows no sign of control or seems unfocused, it can be a warning sign. Heavy spending is a hindrance to profit growth, even if a company enjoys decent revenue. Not all spending is equal, however. Research and development spending that's undertaken by competent leaders is one thing. Hefty spending on advertising that doesn't appear to be paying off, or on executive perks like company jets, might come under scrutiny if a company isn't profitable.
• Other warning signs when a company is losing money include proxy battles that might distract management, dividend cuts, a series of recent management changes in key areas of the business, signs of trouble paying debt, previous guidance retractions (or restatements of previous earnings reports), and criminal investigations or charges against the company or its leaders. All of these represent serious problems. Investors in such stocks should remember that dividends tend to get cut before anything else, and a company with a high dividend but falling or negative earnings is likely sending warning signs.

Anyone with a long-term investment in a company with negative earnings may also face issues beyond their investment portfolio.

A company that once sparked enthusiasm may simply no longer be able to produce as expected. That can challenge someone's sense of investing acumen and even result in denial. At times like these, investors must face the facts and let go of any emotional reasons for holding on. They should be careful to avoid the "sunk cost fallacy."

Stepping back, there may be fine reasons to stick with a company when it loses money. If losses worsen or seem intractable, though, it's important for investors to remember the true purpose of investing in a stock. The idea is to grow profits along with a company, not sink deeper into the muck.