Earnings Quality


  • If earnings have outpaced sales over a long period, need to understand what is driving the delta, as margin expansion is very hard to pull off.
  • If the firm is a serial acquirer, need to worry about two things. First, how much of earnings growth is being paid for by acquisitions? Two, could there be nasty surprises ahead from acquisition because the company was acquired in a hurry and troubles lurk (e.g. this mess that CAT got itself in)?
  • How fast are A/R rising when compared to sales? How are inventories tracking to sales? How are “allowance for doubtful accounts” tracking?
  • Is there a change in the depreciation rules?
  • How much is coming from pension-related charges? (plan assumption related charges will go to AOCI but actual returns on plan assets will hit the I/S and could pump up earnings in good times).

Economic Representative-ness (okay, so I made up a word)

  • are there frequent “one-off” charges?
  • are bad decisions being buried in a big bath of restructuring charge?
  • What is the difference b/w cash flow and earnings, and does the difference switch between positive and negative?
    • Cash flow is pretty clean number, except for one bit:  need to discount the cash flow generated by employees exercising options, usually labeled “tax benefits from employee stock options exercised”. This happens because if an employee cashes in an option trading at $20 and originally granted at $10, the employee has a taxable gain of $10/sh, which implies a taxable deduction of $10/sh for the employer, reducing tax and lowering cash outflow, and thus , obviously increasing OCF, without any change in economics of the business. What is even worse is that this keeps happening as stock of the company keeps going up, reinforcing this distortion.

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