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How to Assess Earnings Quality

June 29, 2014

A company can generate earnings in various ways, some not so trustworthy; I prefer high-quality earnings. In other words, where did the earnings come from?


Did the company post better results because of stronger sales? If sales were strong, was it only because of a single product or one major customer? In that case, the growth is vulnerable. Or are the surprisingly strong results due to an industrywide phenomenon or an influx of orders from numerous buyers?


Maybe the company is slashing costs and cutting back. Earnings improvement from cost cutting, plant closures, and other so-called productivity enhancements walks on short legs. Such improvements can show up from time to time, but sustainable earnings growth requires revenue growth.


Examining earnings quality gives you perspective and  rationale before you commit your hard-earned money to a stock.



Differential Disclosure


When a company says one thing in one document and something quite different in another, you have differential disclosure. This happens far more often than most people think. The reason is simple. Guidelines for reports to shareholders are far less restricted than those for reports submitted to the SEC. An example is shareholder reporting versus tax reporting.


Make a point to compare footnotes and other disclosures related to taxes under the cash-basis accounting rules required for the Internal Revenue Service (IRS) with the earnings reported to shareholders under accrual accounting. If you spot a big difference, this is a red flag. In a similar vein, if a company is reporting great earnings but is not paying much in taxes, be skeptical.



Beware Profitability via Cost Cutting


With an understanding of the three major drivers of earnings (higher volume, higher prices, and lower costs), it pays to be cautious if a company is delivering only on cutting costs. A company can increase profits by cutting jobs, closing plants, or shedding its losing operations. However, these measures have a limited life span.


Eventually, a company will have to do something else to grow its business and increase its top line. Therefore, check the story behind earnings growth. Make sure that it’s not because of a one-time event, because sales jumped as a result of some extraordinary gain, or because profits improved only as a result of cost cutting.


Companies with good potential for stock price appreciation show evidence that earnings growth is sustainable and will continue over some length of time. The ideal situation is when a company has higher sales volume with new and current products in new and existing markets as well as higher prices and reduced costs. That’s a winning combination.


In general, the best growth candidates have the ability to expand, introduce new products and services, and enter new markets. They have the power to raise prices, and they can improve productivity and cut costs. The combination of revenue acceleration and margin expansion will have a dramatic effect on the bottom line.


The worst situation is when a company has limited pricing power, its business is capital-intensive, margins are low or under pressure, and it’s faced with heavy regulation, intense competition, or both. An example would be the airline industry, which doesn’t have much pricing power, faces government regulatory pressures, is very capital intensive, and is highly commodity-sensitive because of fuel costs.


When strong earnings are reported, check the story behind the results to make sure the good news is not due to a one-time event but is the product of conditions that probably will continue. Your questions should include the following:


·        Are there any new products or services or positive industry changes?

·        Is the company gaining market share?

·        Is the company #1, 2 or 3 in its industry? A market is ultimately dominated by just a few companies.

·        What is the company doing to increase revenue and expand margins?

·        What is the company doing to decrease costs and increase productivity?



Excerpt from Trade Like A Stock Market Wizard by Mark Minervini (McGraw Hill Publishing –2012)



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