Investor Toolkit: Knowing how to read between the lines of a corporate earnings statement can help you find winning stock picks

Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a new or experienced investor, these weekly updates are designed to give you specific advice on the fundamentals of successful investing. Each Investor Toolkit update gives you a fundamental tip and shows you how you can use it to increase your chances of making winning stock picks.

Today’s tip: “Corporate earnings statements can help you find winning stock picks if you read between the lines.”

A company’s earnings are different from an employee’s salary. Earnings are indefinite and subject to revision, even years later. Companies have to estimate many costs, and make yearly write-offs against earnings, according to arbitrary rules.

Here are three things to pay special attention to when examining a company’s earnings statement:

• Research spending. Companies mostly write off research costs when they spend the money, depressing the year’s earnings. Some research turns up nothing of value. But research can lead to new or improved products that generate huge future profits and cause a winning stock pick’s shares to soar.

• Depletion write-offs. Mining companies take yearly write-offs against earnings for sums that represent depletion of their mineral reserves. These deductions are supposed to offset the cost of finding and developing new mineral deposits as old ones run out of ore.

  However, mining companies base depletion charges on costs — what they spent to find and develop current mineral deposits. But there’s an element of chance in all exploration. You can never be sure a mine will be profitable until production begins. The same exploration outlay may not turn up an equally rich deposit, or anything of value. When a mining company exploits a rich deposit, its earnings may be partly a return of the original investment.

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• Goodwill write-offs. When one company buys a business for more than the value of tangible assets, such as land and equipment, it treats the excess as “goodwill,” or “value as a going concern.” Every year, the company assesses its goodwill and adjusts its value accordingly. For example, if the value of the acquired business has declined, the company will write off a portion of its goodwill.

  However, goodwill needn’t lose value or depreciate every year. With proper management, the acquired company’s value as a going concern may rise.

To profit from earnings, look at them in context, and consider the historical pattern. It’s a good sign if a company makes money every year, but successful investors mostly avoid chronic money losers.

Next Wednesday, June 23, 2010, Investor Toolkit will look at how you should respond if you hear bad news about a stock you hold.

You can get our full analysis, including clear buy/sell/hold advice, on 16 U.S. companies in the latest Wall Street Stock Forecaster. What’s more, you can get this issue free when you subscribe today. Click here to learn how.