A red flag investors might miss

By Harry Domash

Stocks typically go up when they beat profit forecasts and down when they miss. Knowing that, you should do everything possible to avoid stocks likely to disappoint when earnings reports roll in.

That's why you need to look under the hood to see how your stock manages to come up with its profit numbers during this or any other earnings season.

One big red flag signaling a probable future earnings miss is if a cut in corporate income tax rates, rather than real business improvement, powered recent earnings growth. Here's why that's serious trouble.

When down looks like up

The earnings-per-share, or EPS, figure that gets all of the attention at report time is net income divided by the number of shares out in the marketplace. If net income is $1 million and there are 500,000 shares available in the market, the company earned $2 per share.

That sounds simple enough, but it isn't. You need to pay attention to how net income is calculated. Net income is a company's total income (similar to operating income) minus the corporate income taxes due on that amount.

And that's the rub. Corporate income taxes typically take between 30% and 40% of pretax income. But not always. Sometimes companies pay a much lower tax rate, even at times below 20%.

When a change like this happens, earnings can look like they're skyrocketing, when in fact, pretax income is flat. Here's an example.

Say Company A and Company B both earned $1 million in pretax income and both had 1 million shares outstanding, but they paid different corporate tax rates. Company A paid 40% of income, but Company B paid only 20%.

Check out how the math works. Company A's net income was $1 million minus its $400,000 tax bill (40% of $1 million). So, Company A earned $600,000, or 60 cents per share. Because, after taxes, Company B's net income was $800,000, it earned 80 cents per share. Thus Company B's earnings per share were 33% higher (80 cents versus 60 cents), even though both generated the same pretax income.

Using those numbers, you can see how a company with flat pretax income could appear to have grown year-over-year earnings by 33% if its tax rate dropped to 20% from 40%.

The tax man giveth and taketh away

Here's an example that shows how this works in real life:

In 2006, medical-device maker SonoSite's (SONO, news, msgs) annual earnings per share gained a healthy 26%, to 43 cents per share. Did SonoSite make more money in 2006? Quite the opposite. Its 2006 pretax income was $7.81 million, down slightly from $7.85 million in 2005. The secret sauce? SonoSite's 2006 tax rate dropped to 7.5% from 30.7% in 2005.

Thanks to the lower tax rate, SonoSite's net income rose in 2006. But in 2007, when SonoSite's pretax income gained a healthy 41%, to $11 million, its EPS, instead of growing, actually dropped to 40 cents per share. Why? You guessed it. SonoSite's corporate tax rate moved back up, to 37.5%.

(I'm using 2005-07 numbers because in 2008, the global economic downturn distorted everybody's numbers.)

Continued: The trouble with taxes

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