Give a S%&t About "Earnings Quality"

Let’s say you own a single share in a single company. Four times a year the company as required by law (be smart: governing agency is the SEC) will release its quarterly earnings (sound smart: 8-k). Normally this will happen during “earnings season”, an intense month long season for the on and off Wall Street folk as companies bombard them with their financials. Some companies issue short reports, highlighting the positives in the business and briefly touching upon the negatives. Even when they do mention the negatives they are often explained as not that much of a problem. What CEO would want to come out and say the business he is responsible for overseeing stinks? None if they want to keep their cushy high paying jobs and avoid a massive sell-off in their stock prices.

Other companies decide to release highlights, or short takes, on three months of financial performance, doing so in our opinion to divert investor attention from the most important facts that should impact a person’s willingness to hold, sell or buy more of the stock. Or, as we have seen in countless cases, the business is so darn complicated that it requires a 20 page overview (be smart: earnings releases from banks are the worst). Nevertheless, it’s vitally important to pay careful attention to something our editor calls earnings quality. Here are examples of companies having bad earnings quality, which may hurt the stock performance if the numbers look so good on the surface that the stock is bought initially.

•Sales are signcificantly influenced by recent acquisitions and currency exchange rates. You want to see strong “core” sales from pre-existing operations.
•Profits are significantly influenced by (1) sales of assets for a gain; and (2) a large drop in the rate; and (3) buying back stock that reduced the number of shares outstanding.

These are the basics, and the weapons used by us to detect whether a company’s earnings quality is subpar. Remember, subpar earnings equals subpar share price.