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Earnings Quality
Sectors: Fundamental
Earnings
and earnings growth are the fuel that drives stock prices. However,
what if those earnings arent all that they seem? Companies can come up
with creative ways to exhibit strong earnings growth, which can mislead
investors. It is important to know the quality of the companys earnings
as well as the growth rates and estimate revisions. So what is earnings
quality?
Quality Control
Earnings
are high quality first and foremost when they can be repeated.
Countless companies play games by including one-time gains into their
earnings per share calculations. Most firms have investments of their
own in other companies, and like us, they sell those shares. Gains from
sales of investments are a popular way to inflate earnings and reduce
their quality. There are only so many times that a company can use the
profits from their investment sales to pad earnings. We want operating
earnings from the companys core businesses.
High quality
earnings are important because they are awarded with higher
price/earnings ratios, which directly translate into higher stock
prices. This makes intuitive sense because by definition, these
earnings are repeatable, so investors can bank on them recurring more
frequently, and thus feel comfortable paying more for them.
INTC and MOT Played That Game
Intel
and Motorola are two companies whose earnings per share numbers have
repeatedly benefited from the sale of investments. These two giants
have numerous investments purchased with their enormous cash hoards,
and they would include the profits from these sales in their EPS
numbers. A few years ago in 2001, Motorola reported third-quarter
earnings that soundly beat estimates, but the stock fell over 10%
because investors realized that the earnings were low quality and not
repeatable. This was during a vicious bear market, so it was
understandable that the company wanted to make their earnings look
good.
What to Look For?
Strong
sales growth and cost cutting are crucial to recurring earnings.
However, cost cutting can only last so long, so that leaves sales
growth as the engine of high quality earnings growth over time. Beware
if a companys sales growth starts to slow, but its earnings keep
registering healthy gains. This has been the case with IBM over the
past few years. Revenue growth has slowed to the low-to-mid single
digits while earnings per share have often grown by double digits. Wall
Street grew wise to this and didnt reward IBM with big stock price
gains if sales growth was absent.
Cost cutting is necessary
and good, but the big gains will come from stocks that show explosive
and consistent revenue growth. Otherwise, where will the incremental
earnings come from? Business executives should be spending their time
figuring out how to grow revenues rather than ways to pad EPS numbers
by using tricks. There is only so much fat to cut before you hit bone,
so look to the top line to improve your bottom line. |
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