Earnings Per Share (EPS) is one way for investors to evaluate whether the financial performances of companies are up to the investor’s expectation. From the surface, this is usually the number that will drive the direction of the subsequent stock prices. However, sometimes the market movement may surprise investors as it goes contrary to the reported financials. Instead of going up, the stock price goes the other way even though the presumption of earnings outweighs the expectation.

 

To avoid such unpleasant surprises, experienced investors and analysts will take one step further to look into the financial reports to seek for more clues on the quality and not just the quantity of the companies’ performances. At the end of this article, learners will be able to identify several types of earnings and how it effects their investment decisions.

 

What Are Quality Earnings?

When we talk about a company with high quality earnings, it basically means that the company is able to produce reliable earnings which are stable, persistent and are not involved much in earnings manipulation. However, this does not mean that all companies with low earnings quality are involved in earnings manipulation. Some companies with seemingly good earnings might have some earnings sources, which could mislead investors to believe that their companies are having consistent or dependable earnings.

 

Investors are not auditors. As such, they are not in a position to find out whether the companies are involved in any untruthful act of reporting. But, there are a few earnings characteristics that we can use to try and identify earnings of good quality from the financial reporting of the companies.

 

 

 

• Sustainable earnings – Companies with sustainable earnings are the ones which consistently deliver earnings that are relatively predictable and highly correlated with the industry or economic cycle. When a company shows strong earnings growth, especially when others were struggling to meet their targets, investors will have to be more careful to look into the earnings numbers. There are times that companies increase their earnings through exceptional items, like sales of investment or assets, which are one-off items that are not repeatable. Sustainable earnings are earnings generated from the core businesses, through gaining market share, technology breakthrough or product expansion.

 

When the business environment becomes more challenging or during economic downturn, companies may have to take cost cutting measures in order to achieve earnings targets or reduce their losses. In these cases, investors will have to evaluate the cost reduction actions to ensure that the actions being taken are necessary and reasonable steps that bring better competitiveness to the business. Certain actions, such as job cutting may be able to increase the earnings, but, if critical positions are affected, it may be detrimental to the company’s future.

 

• Controllable earnings sources – there are many factors that could cause the earnings of a company to fluctuate, some of which are not directly controllable by the management of the company. For example, if a company requires raw material from a European country and as a result of the weakening in Euro dollar, the company managed to purchase the raw material cheaper after conversion. This will boost its earnings. This type of earnings enhancement is not an effort by the management and when the exchange rate goes the other way, the earnings will be negatively affected. Investors will have to be careful to exclude such an earnings boost to evaluate the real earnings capability of a company. Of course, the best source of earnings should be derived directly from the sales of the company’s products and services.

 

• Low accruals – earnings are made up from cash flows and accruals. Accrual accounting principles dictates that sales are recorded as revenue once the products are shipped or services are rendered. The difference between the cash earnings and receivables will be recorded as accruals. However, as accruals are made with estimation, thus, it is highly subjected to error. Negative earnings surprises may arise if customers defaulted on their payment or products are returned.

 

During bad times, when companies are desperately fighting to meet their earnings targets, some companies may even stock up their distributors with inventory in order to inflate their earnings. If the distributors are unable to sell off the products, these products will be returned to the company at a later date, which will have a negative impact to the company’s earnings in the subsequent periods. Therefore, earnings with low accruals are usually viewed as high quality earnings as it is less prone to negative surprises.

 

 

Conclusion

It is very important for investors to be able to identify the above characteristics when evaluating the earnings quality of a company. Investors must pay more attention to the small prints that provide explanation to the financials. From here, they will be rewarded with higher investment returns as companies with high earnings quality will eventually be translated to higher stock prices.

 

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*Note: This article was written by Mr Ooi Kok Hwa, holder of the Capital Markets Services Representative’s License to carry on the business of investment advice under the Capital Markets and Services Act 2007. The information provided in this article is only for educational purposes and reflects the market conditions at a specified point in time, which may lapse and affect the relevance of this article. This article does not necessarily represent the official view of Securities Industry Development Corporation and should not be used as a substitute for legal or other professional advice.