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How to Determine Earnings Quality (Part 2)

August 18, 2014

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.


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? 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?


Measuring Margins


The objective for any company is to retain as much money as it can from the revenue it generates, meaning that it has the highest profit margin possible. When margins expand, the company is getting a higher price for its products or has found a way to improve productivity or cut expenses, sometimes both. Increasing margins show that more profits are being made for each dollar of sales the company makes.


Margin metrics come in different varieties. Gross margin reflects how much more customers pay for a product compared with the company’s costs. It shows investors how well a company is doing in keeping its costs in line and pricing its products. Gross margins depend on quite a few variables, some of which may be beyond the company’s control, for example, if raw material costs were lower one quarter or if a competitor had a delivery problem that gave the company an unexpected advantage that could be a short-lived phenomenon. The best kind of margin improvement comes from pricing power because of strong demand for a company’s products.


Net margin is based on a company’s net income divided by sales and reflects all the variables that influence profitability. A falling net margin indicates that the company is making a smaller profit on its sales. This could be due to rising costs, inefficiencies, or taxation. Margin pressure can cause serious profit erosion. The cause of a decline in net margins could be temporary in nature, such as a short-term rise in raw material costs or temporary inefficiency in the production system. Far more worrisome is when the net margin declines because prices are dropping as a result of declining customer interest.


A company with a strong net margin compared with the average in the industry has a competitive advantage. A comparison of net margin across companies in an industry can be used to gauge the quality of management. A well-run growth company should show consistent improvement in operating margins and net profit margins.


Where the Rubber Meets the Road


No matter how good an earnings report appears to be on the surface, you want to pay close attention to the stock’s price reaction to determine how good the report really was or was perceived to be. One way to do this is simply to watch how the stock trades initially and over subsequent days after the earnings release. If the report really was great, you should see a strong stock price reaction that holds up and is supported by additional buying on reasonable pullbacks. I like to see the stock price react strongly to the report and hold its gains.


To determine whether the market is looking favorably on a company’s earnings, I watch for three specific reactions:


1. Initial response. Did the stock rally or experience a sell-off? If it sold off, does it resume its slide after a dead cat bounce? Or, does the stock price come roaring back?

2. Subsequent resistance. How well did it hold its gains and resist profit taking?

3. Resilience. Did the stock recover quickly and powerfully? Or did it fail to rally after a pullback or, worse, sell off?



Excerpt from Trade Like A Stock Market Wizard; How to Achieve Superperformance in Stocks (McGraw Hill 2012)  


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