There is no debating that stocks with high-quality earnings are more likely than others to beat the market. But how do you know quality when you see it? Here we help you answer this question.

Quantity Vs. Quality
Earnings quantity (not quality) tends to get the lion's share of attention during quarterly reporting seasons. Investors focus on actual cents per share delivered, resulting either in share prices going up when companies beat earnings estimates, or falling when numbers come in below projection. At first glance at least, when it comes to earnings, size matters most to investors.

Savvy investors, however, take time to look at the quality of those earnings. The quality rather than quantity of corporate earnings is a much better gauge of future earnings performance.

Firms with high-quality earnings typically generate above-average P/E multiples. They also tend to outperform the market for a longer time. More reliable than other earnings, high-quality earnings give investors a good reason to pay more.

Defining Quality
So, how do investors identify a firm with quality earnings? When analyzing quarterly reports, investors should ask themselves three simple questions: Are the company's earnings repeatable? Are they controllable? And finally, are the earnings bankable?

  • Repeatable Earnings
    Consider Motorola's 2001 third-quarter earnings, which demonstrated the importance of repeatability. In spite of a slowing economy and sales shrinkage, the technology giant posted earnings of four cents a share, well ahead of Wall Street estimates. Some of those earnings came by way of job cuts, and a sizable chunk came also from the sale of investments.

    In the weeks following, the stock dropped by 15% because the market realized that Motorola's earnings quality was questionable: the sale of assets is never repeatable. Once sold, assets cannot be sold again to produce more earnings. At first, investors were unwilling to pay for high quarterly earnings, but found later that the company would never be able re-produce such future earnings.

    Sales growth and cost cutting are the best routes to high-quality earnings. Both are repeatable. Sales growth in one quarter is normally (albeit not all the time) followed by sales growth the next quarter. Similarly, costs, once cut, typically stay that way. Repeatable and fairly predictable earnings that come from sales and cost reductions are what investors prefer.

  • Controllable Earnings
    There are many factors affecting earnings that companies cannot control. Consider the effects of exchange rates. For example, if a company must convert its European profits back into the U.S. dollar, a dollar that is falling against the euro will boost the company's earnings. But, management has nothing to do with those extra earnings or with repeating them in the future. On the other hand, if the dollar moves upwards, earnings growth could come in lower.

    There are other uncontrollable factors that can raise earnings. Inflation, for instance, can give companies a brief profits boost when products in inventory are sold at prices increased by inflation. The price of inputs is another uncontrollable factor: falling jet fuel prices, for example, can improve airline industry profits. Even changes in the weather can boost earnings growth. Think of the extra profits that electrical utilities enjoy when temperatures are unusually hot or cold.

    Let's face it, the highest-quality earnings go straight to the bank. Indeed, cash sales - which the company does control - are the source of the highest-quality earnings; investors should seek firms with earnings figures that closely resemble cash that is left after expenses are subtracted from revenues.

  • Bankable Earnings
    Most companies, however, must wait before they can deposit revenues in the bank. Cash payments often arrive later than receivables, so most companies, at times, enter sales as revenues, even though no money has exchanged hands. The fact that customers can cancel or refuse to pay creates large uncertainties, which lower earnings quality. At the same time, generally accepted accounting principles give room for choices about what counts as reliable revenues and earnings.

    For some firms, there is a strong temptation to count their eggs before they hatch. For instance, Harley Davidson's 26% profit growth in 2001 looked impressive, until you note that a good chunk of its profits came from packaging and selling loans made to motorcycle buyers. Harley Davidson Financial Services contributed 13 cents to its parent's 2001 earnings.

Clearly, high earnings are not as important as high-quality earnings: those which are repeatable, controllable and bankable. Earnings that experience a surge because of a one-time, uncontrollable event are not earnings that are inherent to the activities of the business. These earnings are the result of luck, which is never a reason to invest. Finally, those business that generate revenue but not cash are not engaging in profitable activities. When you invest, make sure your company is taking its earnings to the bank!

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