Assessing Earnings Quality

A company can yield revenue in various ways, some not so reliable. Earnings that are improved from cost reduction and plant closures walk on short legs. Such developments can show up from time to time, but sustainable earnings growth needs revenue growth.

You should look for earnings that come from main operations, not from a one-time gain or an extraordinary circumstance.

Company Managements have become proficient at regulating expectations and fondling numbers to underpromise and over-deliver. This should raise a caution alarm because the report may not be as good as it appears to be.

Inventory write-downs and ongoing expenditures should also be looked out for. Few companies will store write-downs for future needs. They may choose to shift revenues or expenses into a different accounting period, which enables them to influence in which quarter they will realize expenses or recognize sales.

Earnings should come from strong core sales and not from accounting conspiracies.

The perfect situation is when a company has higher sales volume with new and current products as well as elevated prices and smaller costs. That’s a winning synthesis.

The worst circumstance is when a company has restricted pricing power, its business is capital-intensive, margins are poor, and it is facing intense competition or heavy regulation, or both.

To ascertain whether the market is looking favourably on a company’s earnings, Mark watches for three distinct reactions:

• Initial response- Whether the stock rallied or experienced a sell-off. If it was sold off, did it proceed with its slide or did it come roaring back? 
• Subsequent resistance-  How well did it hold its progress and resist profit-taking?
• Resilience-  Whether the stock was restored promptly and powerfully or did it fail to rally after a pullback or a sell-off?

For a true super performer, there should not be a massive sell-off that halts the leg of the stock’s upward move.

For specific industries, such as manufacturing, the comparison of stock and sales is vital.

Consider inventory as a product waiting to be sold. Under most circumstances, inventories should rise and fall according to the sales. 

When inventory grows much faster than sales, it can reflect reducing sales or misjudgment of future demand by the organization.

The receivables part of a company’s balance sheet deserves attention. Accounts receivable are what the company has to collect for sales it has already made. If receivables are increasing at a greater rate than sales, this could be an indication that the company is having difficulty receiving from its customers.

If receivables and inventories are both increasing at a greater rate than sales without explanation, this could be a twofold danger. 

This kind of situation should put up a warning.