When looking at earnings quality, we at The Motley Fool have two databases -- EQ Scan and EQ Score -- that help us to uncover cash flow and revenue recognition issues. Smart financial officers can use several techniques to manipulate financial results, and manipulation of any of the three financial statements usually affects the other two. But a critical eye on these statements can often uncover trends that could be important for investors to understand to help protect against them losing their hard-earned money.
The EQ Score database assigns an index rank to the company from 1, for the lowest quality, to 5, for the highest. As the company's financial status changes over time, the database adjusts its rank and illuminates trends that will affect earnings quality going forward.
Recently, we looked at the EQ Score for priceline.com
Priceline's stock price increased 50.74% last quarter and currently sits around $755 a share. Similarly, Apple shares have increased 50.43% since the start of 2012 and are near $625 but off their recent high of $632. By contrast, Google shares have declined by 2.78% and are currently at $635 a share.
TMF's EQ Score database shows Priceline with a lowly score of 1 and a downward trend in earnings quality since the start of the year. Apple's score is a 2, also with a downward trend. Google's score is also a 1, down from 2 a few weeks earlier.
|
Stock |
Trailing P/E |
Forward P/E |
Price/Sales |
|---|---|---|---|
| Priceline | 36.16 | 19.43 | 8.53 |
| Apple | 17.77 | 12.47 | 4.55 |
| 21.23 | 12.59 | 5.45 |
Priceline is more richly valued relative to earnings and sales than either Apple or Google. Now let's look at price and earnings-per-share estimates.
|
Stock |
Current Price |
2011 Year-End Price |
5-Year Average Price Growth |
EPS Estimate 2012 |
EPS Estimate 2013 |
Estimated % Increase/Decrease |
|---|---|---|---|---|---|---|
| Priceline | $755 | $485.15 | 207.7% | $31.22 | $38.31 | 22.71% |
| Apple | $624 | $411.23 | 75.9% | $43.96 | $50.00 | 13.74% |
| $635 | $665.41 | 6.5% | $42.56 | $50.17 | 17.88% |
Source: Yahoo! Finance.
PCLN Net Income data by YCharts
AAPL Net Income data by YCharts
GOOG Net Income data by YCharts
Each company exhibits powerful growth in revenue, net income, and EPS. Priceline, however, shows seasonal spikes. I used five-year averages to smooth the data.
|
Stock |
5-Year Revenue Growth % Average |
5-Year Net Income Growth % Average |
5-Year EPS Growth % Average |
5-Year Shares Growth % Average |
|---|---|---|---|---|
| Priceline | 41.2% | 125.6% | 95.4% | 7.8% |
| Apple | 48.2% | 87.8% | 82.5% | 1% |
| 25.7%% | 26.3% | 24.6% | 0.8% |
Source: S&P Capital IQ.
I added the last column to indicate that each company's outstanding shares have increased on average over the past five years. None of these companies is manipulating net income to boost EPS by decreasing the float. Obviously, they don't need to. In fact, since outstanding shares are rising modestly, the effect is to depress net income slightly.
More importantly, EPS growth over the past five years has been stellar for all three of these highfliers. But look at those EPS estimates going forward: A 22.71% increase for Priceline, 13.74% for Apple, and 17.88% for Google. The growth rate for each company is slowing down.
Without considering each business model or economic conditions going forward, the data shows three companies experiencing different rates of growth in revenue and net income. All three have forward P/Es that are less than estimated EPS. Using this metric, each company would be a potential "buy," but if you compare trailing P/Es with EPS, then all three look much less attractive for purchase.
The trend data reflects Priceline and Apple's significant price appreciations this year that have outpaced estimated growth rates. The EQ Score database warns us when this happens by lowering scores, and it also lets us know when growth rates slow. We should expect the rate of price appreciation to abate, but that doesn't mean these companies won't continue to grow or remain the market leaders they've become. The data does demonstrate that price doesn't perfectly correlate with revenue and/or earnings and will vary. As always, then, prudent fools should make investment decisions based on consideration of earnings quality.
For more on Apple, check out The Motley Fool's brand-new free report, "5 Stocks Investors Need to Watch This Earnings Season." It details what to look for from Apple and four other must-watch companies as they report their latest results. You can get instant access to this free report.
