Earnings Sustainability: The Key To Your Investing Future

By Joseph Nguyen AAA

Evaluating company valuations for investment purposes is a difficult task. Frequently, investors will use valuation ratios, such as the price-earnings (P/E) ratio, and compare them with similar companies to determine if it's relatively cheap or expensive. In conjunction with ratios like the P/E, investors should look at the sustainability of the company's earnings. A company that reports abnormally high earnings in one period may see the price of their stock shoot up along with their P/E ratio. But will those earnings persist to justify the higher valuations? By analyzing the sustainability of earnings, investors can get a sense of how earnings will behave in the future.

Restructuring Charges / Write-offs
Often, restructuring charges or write-offs by a company are treated as a one-time expense and ignored by investors. However, when doing due diligence during your investment process, you should always pay attention to these items - they could be anything but one-time. For example, a company that has to perform a significant write down on their inventory will continue to be affected by the write down, through a lower cost of goods sold in future years. Similarly, if the company decides that their equipment or plants requires a write down, future depreciation will also be lower. Both these items directly impact future net income, yet are often thrown by the wayside. (For more on write-offs, also take a look at Common Clues Of Financial Statement Manipulation.)

Advertising Expenses
Some companies depend on certain core activities to sustain their earnings. For many companies in which brand recognition is especially important, marketing and advertising expenses are keys on which to focus. Often, a company will create a temporary boost in earnings by lowering their advertising expenses in the current period, but this action may be at the expense of future net income.

To analyze advertising expenses, simply calculate the amount spent on advertising during the period as a percentage of revenues. Compare the percentage spent on advertising over the course of a few years (three to five years is usually good). Large increases or decreases in this expenditure should be investigated further. For example, let's take a look at Coca Cola's advertising expenses (in millions) for 2006-2008.

-- 2008 2007 2006
Net Revenues 31944 28857 24088
COGS 11374 10406 8164
Gross profit 20570 18451 15924
SG&A 11774 10406 8164
Ad Expenses 2998 2774 2553
Ad Expense/Revenues 9.39% 9.61% 10.60%
Source: Coca Cola 10-K

Between 2004 and 2006, Coca Cola's advertising revenue averaged around 10% of sales, and before 2004 it held steadily at around 8.6%. A couple points to look into could be why there was a spike to 10% for three years and now advertising expenses are decreasing back to pre-2004 levels. Was there a temporary boost in advertising that affected future sales or was there deterioration in sales growth rates?

Research & Development
Similar to advertising expenses for companies that rely heavily on brand recognition, look at R&D expenses for companies that rely on a consistent pipeline of new products to sustain earnings. Pharmaceuticals and Tech are examples of sectors that rely heavily on R&D investments. R&D expenses is one of those expenses that are treated as an operating expense yet provides long terms benefits like investments in buildings or machinery. This means R&D gets expensed immediately rather than depreciated like long term assets, and this directly impacts the current period's net income.

A decrease in R&D expenses on the income statement will boost current earnings, but earnings in the long-term may suffer. And an increase in current R&D expenses may lower current earnings but provide benefits in future years. Also, historical increases in R&D that don't result in increased future sales should be a red flag for investors. This could mean the company is becoming less efficient at using R&D investments to produce new products. As an example, let's take a look at Advanced Micro Device's R&D expenses (in millions) for 2006-2008.

-- 2008 2007 2006
Net Revenues 5808 5858 5627
Sales Growth Rate -0.1% 4.1% 13.1%
R&D Expense 1848 1771 1190
R&D/Revenues 31.8% 30.2% 21.1%
Source: Advance Micro Devices 10-K

AMD's sales growth rate dramatically fell from 13.1% in 2006 to essentially no growth in 2008. Meanwhile, R&D expenses were consistently being increased. From 2003-2005, the average R&D expense was about 24.8% of sales. The increase to 30-31% in 2007-2008 should be a red flag for investors. Will the company be able to sustain this level of R&D or is the increase simply due to a struggling success in the R&D department? Or maybe this is a one time increase in R&D and the percentage will revert back to historical levels. These are the type of issues the investor should dig deeper into to understand the core business. (To learn more about R&D and other intangibles, see The Hidden Value Of Intangibles.)

Analyzing the sustainability of a company's earnings is just one aspect of a good earnings analysis. Knowing the company's core business activities and the drivers of its revenue can help investors dissect the consistency of their earnings. Because as an investor you are valuing and buying the company's future earnings, knowing which part of earnings are not sustainable will help you discount the price more accurately. There are also numerous other items that can distort company's earnings such as future pension expenses, unrealized gains/losses on marketable securities, and many others. This article simply provides an introductory look at earnings sustainability.

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