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How to Determine Earnings Quality (Part 1)

August 11, 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.

 

Nonoperating or Nonrecurring Income

 

Depending on how you examine a company’s quarterly report, it can look like a roaring success or a sagging sloth; it’s all a matter of perspective. Here’s how this can happen. XYZ Corp. reports $3.01 per share versus $2.40 the year before. This shows a hefty earnings gain of 25 percent. Looks great, right? On closer examination you notice that XYZ Corp. reported an “unusual gain” related to the sale of nonstrategic assets. This one-time event accounted for $0.84 per share of income and is considered nonrecurring. Therefore, this gain should be excluded from XYZ Corp’s earnings. Doing this will result in an adjusted number of $2.17 a share, which is down 7 percent from the year before. Big difference!

 

I’m looking for earnings that come from core operations, not from a one-time gain or an extraordinary event. Most of the time the difference between operating income and nonoperating income is clear-cut. Consider a company that sells coffee; some of its stores are on company-owned real estate, and management decides to divest some of the properties in the belief that commercial real estate prices are high. These property transactions and the profits they generate are clearly outside of selling coffee. Therefore, any gain on the property sale would be a nonrecurring event or extraordinary gain that should be stripped away so that earnings reflect income from operations derived for the company’s core business.

 

Beware Massaged Numbers

 

Management has become adept at managing expectations and massaging numbers in an effort to underpromise and overdeliver. The game players may even underdeliver by dropping an earnings bomb in an effort to have the estimate bar temporarily lowered for easy comparisons in the future.

 

One gimmick is to warn the public of a potential earnings problem, which will cause analysts to lower their earnings estimates. Then the company reports earnings that are better than the lowered estimate. This will result in an earnings surprise; however, it will be a surprise in the context of a lower consensus comparison. If you see that estimate revisions were recently lowered due to downside guidance, and then the company beat expectations, this should raise a red flag; the report may not be as good as it looks on the surface.

 

One-Time Charge

 

Another smoke-and-mirrors trick is to utilize a one-time charge or a nonrecurring charge. A company that would otherwise report weak earnings may in fact report a nonrecurring one-time charge that will account for a portion of the earnings. It’s just a one-time expense, and business will be back to usual, right? Wrong! Not if this practice forms a pattern. Some companies are habitual abusers of the one-time charge. If the one-time charge is showing up over and over, you should seriously question the earnings quality of even the largest and most respected corporations engaging in this practice. Write-Downs and Revenue Shifting Inventories write-downs and ongoing expenses are also items to look out for.

 

Some companies will bottle up and store write-downs for a later date when they’ll need them. They may choose to recognize or shift revenues or expenses into the future or a different accounting period, which allows them to control in which quarter they will realize charges or recognize sales. Some companies will record revenues and accounts receivable at the time they ship product and estimate losses only for returned merchandise. If returns run higher than is accounted for, it could affect future earnings.

 

Management may also choose to shift earnings so that a hit can be absorbed in a single disappointing quarter. By shifting earnings to have one big down quarter, the company can beat estimates in the next quarter because the previous report prompted analysts to lower their estimates, making it easier for the company to beat the Street. You want to see earnings coming from robust top-line sales, not from accounting tricks and gimmicks.

 

 

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

 

 

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