Looking at Earnings
Earnings are important. Analysts’ research, evaluate, and predict them while all classes of investors interact with earnings in some way. Therefore, earnings quality becomes an important item in analyzing a public company. Earnings quality can be defined by the extent to which the earnings number reflects the economic performance of the company. Immediately trusting that a company has properly reflected their performance would be nice, but is often naive thinking. For reference, a few characteristics of earnings quality are consistent accounting choices over time, avoidance of long term estimates, and sustainability. Those are fundamental parts of a company and the earnings of a company that analysts and investors look for. Having a high earnings quality results in better credit, a lower cost of capital, and a potentially better stock price.
Looking at the factors that can influence earnings quality can provide good perspective for investors. These factors include the business model of the company, macroeconomic conditions, the company’s internal controls, accrual conversions, and the analysts who follow the company. CFO’s at large public companies make decisions with these influences in mind. There are a lot of moving parts involved with company earnings that make beating analyst expectations by $.01 seem impossible. However, it is often the case where your companies miss or beat expectations by pennies per share. How does that happen when there are all sorts of factors influencing the income statement and the quality of the reporting? The simple answer is that the analysts are very good or the financial reporting/accounting teams at the company are incredible. On the other hand, there may be some misrepresentation of earnings occurring that savvy investors can be mindful of.
Obviously, there is pressure to beat earnings or be consistent with earnings. Volatility in earnings can cause stock price descent, lack of bonuses, and endings of careers for people involved. In many cases, these pressures result in some blurring of the U.S GAAP rules and reporting standards that need to be analyzed and discovered. A few of the best ways to catch earnings quality red flags are as follows. The first is a clear divergence between cash flow from operations and earnings on the income statement. If these are heading in different directions for multiple periods, start to be worried. These trends can be spotted in the Sage Data Service Research Platform easily using the year over year and quarter over quarter financials view. Other important items to look for include large deviations from industry peers or competitors. Typically, an industry will move together over time and have similar margins. Lastly, analysts look for large or frequent one-time items in the financials. This can indicate accounting trickery to write-off large losses or make capital expenditures without sufficient explanation. None of these are easy to spot without digging deeper into the financials and having a healthy pessimism towards what is reported.