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Foolish Book Review: "Quality of Earnings"

A book that has a first chapter titled "Don't Trust Your Analyst" can't be all bad. After all, here at The Motley Fool, we believe the person best suited to manage your money is you.

That's exactly what Thornton O'Glove argues in his book, "Quality of Earnings: The Investor's Guide to How Much Money a Company Is Really Making." He writes, "I would like to suggest that you can consult an expert whose advice can be trusted, someone who will be on hand whenever you need him or her, and who can be counted upon not to try to deceive. ... That expert is you, or at least can be, if you make some effort." The rest of the book details where he, at least, spends some of his effort in analyzing stocks.

Oh-so-flexible GAAP
Under U.S. generally accepted accounting principles, there is a lot of room for creativity in how companies report their earnings. O'Glove shows where several of these areas are and gives examples of how companies can present their earnings data so as to look better than they are, while still falling inside GAAP guidelines.

For instance, in the chapter dealing with nonrecurring earnings, he looks at what should be done with investment or interest income. Are they part of operations, as for an insurance company such as Hartford Financial Services Group (NYSE: HIG  ) , or are they not, as for a retailer like Nordstrom (NYSE: JWN  ) ? For the nine months ended last Oct. 28, of Nordstrom's $1.70 basic earnings per share, $0.41, or 23.9%, of that was from income other than selling stuff in its stores. For those who look at the bottom line, should this be included or not when asking whether the company would make a good investment?

A look at inventory
In another chapter, O'Glove discusses why it is important to follow items on the balance sheet, such as accounts receivable and inventories. Don't look at just the final number, but dig in and see what contributes to that number. For instance, if the inventory balance is due mostly to finished goods sitting on shelves, difficulty might lie ahead with slowing sales and/or write-offs. He uses the example of Apple (Nasdaq: AAPL  ) in 1985 to illustrate this point. Its finished-goods inventory had increased by a whopping 293% as of March 29, 1985, compared with the previous year. The company suffered a net loss in the following quarter before rallying. Then CEO John Sculley said that a key reason for the recovery was better inventory turnover.

Applying this lesson to a more recent example, Cisco Systems (Nasdaq: CSCO  ) took a $2.5 billion inventory write-off in the spring of 2001. Careful followers of the company might have noted that for the year ended July 29, 2000, just nine months before that charge, finished goods increased by 76%, compared with 1999, while raw materials increased only 1.4% and revenue climbed 55%. Six months later, finished goods had continued to climb, and the backup had caused raw-material levels to explode as well. If the inventory warning signs in mid-2000 had been heeded, careful investors might have avoided much of the decline that followed.

In the chapter titled "Dividends: The Tender Trap," O'Glove looks at dividends and share buybacks. For part of this chapter, he argues that increasing a dividend payout can lead to a worse return to investors than if the company buys back shares of common stock. He also shows what can happen when a company becomes locked into paying dividends, as illustrated with an earlier public incarnation of Western Union (NYSE: WU  ) .

Other chapters cover topics such as accounting policy changes, debt and cash flow, and the differences between shareholder reporting and tax reporting. He fills each chapter with examples from his time of writing the Quality of Earnings Report newsletter.

Too old to be useful? Not.
The book is a bit dated in that it was published in 1987 and has not been updated. However, the lessons are timeless, because companies will always try to present things in as good a light as possible. While the individual lessons may or may not apply to today's analysis, the core lesson remains true: Be skeptical of what companies say, and look beneath the surface of the financial statements. By paying attention, one can often avoid the companies that are in trouble, or even see trouble developing before the company itself admits it.

While some may view what he wrote with a sense of despair -- I have to do all of that just to become a good investor? -- I don't consider learning how to apply his methods to be difficult. Start small. Become more familiar with one of the companies you own. Read the shareholder letter with a skeptical eye (there's a chapter on this as well), and look at the numbers a bit more closely, using some simple arithmetic to see what is happening over time. Once that is done, do it with another of your companies. With just a few hours each week, or, at worst, each month, you'll become a better investor following the guidelines laid out in this book.

Open your eyes and mind to what the companies are actually doing, rather than just accept the latest tidbit of gossip. That's all O'Glove was writing about. In a broad sense, he was trying to get us to turn up our B.S. sensors by encouraging us to read between the lines and behind the numbers. And if we do that, we can't help becoming better investors.

Western Union is a Motley Fool Inside Value pick. To see why, take our value-hunting newsletter service for a free 30-day spin.

Fool contributor Jim Mueller does not own shares in any company mentioned. The Fool's disclosure policy likes to be read, especially beneath the surface.

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