Take Quality Over Quantity When It Comes To Earnings

Quality doesn’t get much attention in the financial headlines or from investors for that matter. The quality rather than the quantity of earnings is a much better gauge of future performance. Firms with high-quality earnings typically generate above-average P/E multiples – they give investors a good reason to pay more – and tend to outperform the market for a longer time.

There is no perfect definition for earnings quality, but understanding the degree of conservatism within a firm’s income statement is crucial. The best way to accomplish this is to review the firm’s revenue recognition, inventory valuation, and depreciation method – all of which can be found in the Management Discussion & Analysis section of the firm’s 10-K.

Recognizing that most readers lack the time or motivation to make such an assessment about an income statement – that’s what you hire Acropolis for – I won’t get into the gritty details. Instead, you simply need to remember that high-quality earnings are repeatable, controllable and bankable.

Let’s start with repeatable. It’s common to see a brief boost to earnings from a one-time event such as a tax-benefit or the sale of assets, both of which investors can’t rely on to be repeated. For example, the earnings pop a healthcare company gets from selling animal care unit can only happen one time. Sales growth or cost cutting, on the other hand, has a positive effect on earnings that can be repeated. Sales growth in one quarter is normally, but not always, followed by sales growth in future quarters. And cost reductions are not typically reversed quickly, thus investors can expect earnings to benefit from the operating leverage in future quarters.

One-time earnings surges can also be attributable to items out of a firm’s control. Take currency fluctuations for example. A U.S. company with large international operations would benefit from a falling dollar against international currencies since international profits are converted back into dollars. Unfortunately, management has no control over exchange rate fluctuations – this blends in with the previous point in that uncontrollable items cannot be assumed to be repeatable. Other examples of items out of a firm’s control include inflation or deflation – falling jet fuel prices can improve earnings at transportation companies like UPS. Even weather can boost earnings – utilities and coal companies enjoy extra profits when temperatures are unusually hot or cold.

The most important characteristic of quality earnings is that they are bankable. By this I mean that investors should seek firms with earnings figures that closely resemble the cash flow they generate. Cash flow, which firms can control and repeat, is the source of the highest-quality earnings. A company that recognizes revenue before cash is received (using account receivables) faces large uncertainties since customers may cancel or refuse to pay. In this case it is easy to identify the lower earnings quality because the amount of actual cash flow the company generates will be lower than the earnings number (since all of the revenue has not been collected).

The point to take away from all of this is that the earnings number itself isn’t always the best indicator of a successful company. When it comes to earnings, investors should seek out quality over quantity.

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Peter J. Lazaroff, Investment Analyst