When is a dollar not a dollar? Did you ever hear someone refer to "quality of earnings"? Why do they say that? Is there a such thing as earnings that lack quality? Actually from an investment perspective there is.
I have given this a lot of thought, but most often in terms of real estate. Sometimes properties that are being prepared for sale have a lot of cosmetic improvements made while important maintenance and operational activities are suspended to show increased profit. History has shown us that it is not uncommon for companies to 'dress up' quarterly reports in the same manner. That is why smart real estate investors always want to see expense records for several years. The following was found on Investopedia.com:(http://www.investopedia.com/terms/q/qualityofearnings.asp)
- Quality earnings are the amount of earnings attributable to higher sales or lower costs rather than artificial profits created by accounting anomalies such as inflation of inventory.
- Quality of earnings is considered poor during times of high inflation. Also, earnings that are calculated conservatively are considered to have higher quality than those calculated by aggressive accounting policies
Put simply, quality earnings come from selling more product, expanding revenue and profit margins while increasing shareholder equity. Non-quality earnings come from temporary good fortune that might be related to new tax law, abnormally lower energy prices, or extending differred maintenance on plant and equipment. This last one is often used to temporarily help the bottom line, and may be portrayed as being more efficient. However, unless some operational manuever creates an increase in business producitvity and top line growth, the fact that short term profits are up does not represent 'quality earnings'.
One thing not mentioned above that I consider important to a discussion of quality earnings are 'regular earnings'. Does the top line and bottom line represent recurring revenue that can be counted upon and hopefully repeated.
If I were to draw a cartoon image to represent this story I think it would be of a little boy and his father standing by an ice cream truck, with the boy pulling a $50 out of his pocket to treat his dad. In amazement the dad can't help but exclaim "Where did you get that?!" Sometime you want to ask the same question when you review the financial reporting of public companies.
Those of you who are new to BloggingStocks can check out my other stories and read Chasing Value or Serious Money to find more potential opportunities and verify my track record as well.
Sheldon Liber is the CEO of a small private investment company and the vice president for design and research at an architecture & planning firm. Check out his other posts for BloggingStocks here.
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