First Thing's First

Earnings Quality – what is it and why is it important?

          I’ll take it in reverse: EQ is important because earnings are the basis for valuing a stock. ‘Earnings’ here does not refer to net income specifically, but rather to whatever measure is used for valuing annual economic performance. Net income is a pretty bad measure for this, because it is impacted by and susceptible to such a wide variety of factors that are not going to be indicative of the underlying, ongoing economics of the business. Better measures include free cash flow to the firm (FCFF), net operating profit after-tax (NOPAT), or even operating cash flow less CapEx (if you want to rely on a third party source and not do any calculations yourself).

          So what is earnings quality? Quality of earnings measures the degree to which reported operating results accurately reflect the economic performance of the business. Put another way: to what extent can we accept management’s reported results at face value? There are many ways to assess and measure earnings quality (and those will be discussed extensively here in the future).


Application – micro and macro

          From an individual company perspective, the application for earnings quality analysis is fairly obvious. The process is basically:

          - how did reported results compare to consensus expectations?
          - were there earnings quality issues that could account for the positive or negative surprise versus expectations?
          - does the combination of stock price movement due to earnings surprise and the presence of earnings quality issues provide an opportunity to make money (long or short)?
 

          Another more subtle implication is that management intent is basically irrelevant for this analysis. For example, whether the quarterly reported sales exceeded consensus estimates due to aggressive accounting assumptions by management or due to the (appropriate) application of a new revenue recognition standard that was not fully understood by consensus views still drives the same conclusion for earnings quality analysis. Namely, the recently reported results were aided by an accounting or reporting phenomenon that was not discounted in the consensus view. This then requires assessment of whether such phenomenon is recurring and sustainable, or whether it constituted a non-recurring effect on results (which by definition is likely to reverse subsequently).

          From a macro perspective, I think there is an important and under-appreciated long-term trend affecting comparability of stock indices (such as the S&P 500) over time and the respective P/E multiples applied to them. The proliferation of non-GAAP earnings measures being reported by the vast majority of public companies currently creates a comparability issue with historical valuation measures. Although I have not done the formal work (not enough hours in my day), the hypothesis is that a larger and larger proportion of companies now utilize and report (and perhaps more importantly, Wall St sell-side analysts now base their coverage and estimates upon) some variation of ‘adjusted’ or ‘non-GAAP’ earnings. Increasingly, this typically just represents ‘earnings without the bad stuff’. Even when adjusted EPS appropriately only removes truly non-recurring items, the issue of comparability with historical periods still persists. This makes comparison of today’s market P/E multiple to that of previous cycles less and less relevant.


It’s a market of stocks

          So why do earnings quality analysis? Because the stock market is not (necessarily) the index. Sure, the right answer for many (most?) individual investors is to index. But for professional investors or individuals with the skill set, it is important and potentially very profitable to understand that it is a market of stocks – each an individual company with specific factors affecting value.

          By definition, any index is going to include a lot of losing stocks. Analyzing earnings quality is an important tool in identifying and avoiding (or shorting) those. The actual numbers might surprise you. Here is but one of many examples showing how high a proportion of stocks in the index are actually long-term losers, and by definition, how the index’s positive long-term returns end up being due to a select few stocks that massively outperform. This particular study looked at the period from 1983-2007, examining 8,054 stocks that would have qualified for membership in the Russell 3000 at some point in their lifetime. 39% of these stocks produced a negative lifetime total return, and 18.5% declined by 75% or more. 64% of stocks underperformed the Russell 3000 index. The bottom 75% of these stocks collectively had a total return of zero, while ALL the gains were attributable to the top 25% of stocks. “In other words, a minority of stocks are responsible for the majority of the market’s gains.” Del Vecchio mentions this study in his book, which is highly recommended.