Reporting season really hits its stride in April. As the Q4 reports start pouring in, most investors will be paying attention to how many dollars and cents per share businesses deliver in earnings. When a company beats the Street's estimates, its share price will more than likely jump. When earnings fall short, prices drop.
But Fools know that it's quality, not quantity, that counts. It's vital to look closely at the quality of those earnings, which is a much better gauge of future earnings performance. Firms with high-quality earnings typically generate above-average returns, and give investors a good reason to pay more for their shares. That explains, at least partly, why companies like General Electric
So, how does a Fool detect quality? There are several ways. But the next time you are poring over financial reports, ask yourself three questions: Are the earnings repeatable? Are they controllable? And finally, are they bankable?
Are the company's earnings repeatable?
To see why this one is important, consider Trizec Properties'
Quite simply, there are two quality ways to boost earnings: increase sales and cut costs. Fools give them a stamp of approval because they're repeatable. Sales growth in the current quarter usually -- but not always -- leads to sales growth next quarter. Once they are cut, costs usually -- but again, not always -- stay that way.
An asset sale, on the other hand, isn't repeatable. Once sold, Trizec's "surplus" property holding can't be sold again next quarter. And tax gains don't come every year. The income created from both was certainly real, but Fools are more than justified if they decide not to pay the going multiple for those parts of Trizec's earnings.
A sale of assets is just one source of non-repeatable earnings. Sales of other assets like shares, lump-sum royalties, and up-front franchise fee payments also generate earnings growth that might just be a temporary spike above a lower and more sustainable growth rate.
Does the company have control over earnings?
Energy producers are generating record earnings. ChevronTexaco's
The dollar sliding in value against the euro helped farm equipment maker Deere & Company
If exchange rates or energy prices move in an unexpected direction, sustained growth won't last for oil companies like ChevronTexaco and exporters like Deere. And there's not much they can do about it. With these management teams having so little control over much of their earnings, this type of earnings growth makes their stock less predictable and less valuable. Fools calculate a discount for these lower-quality earnings to come up with an attractive purchase price.
Are they cash earnings or just book entries?
Revenues -- the key source of earnings --come in two kinds. First, there are cash revenues that normally can't be recalled by customers. Second, there are non-cash revenues, where a company makes a sale and does not receive payment by the time the books close for the quarter. In this case, sales receipts are treated as revenue although no money has changed hands yet.
All things being equal, Fools prefer companies that produce cash revenues. Cash sales rarely get wiped off the books, and go straight to the bank. By contrast, it's hard to gauge the certainty of accounting revenue. Customers can renege, cancel, or refuse to pay. In fact, managers will tell you that when new products get introduced many customers will frequently double-order, fully intending to cancel the order for either the old product or the new one. This is the kind of problem that big product suppliers like GE regularly face. It takes a disciplined, well-managed company -- like GE -- to stop itself from double-counting those sales. That kind of mix-up inflates revenues and earnings and then sends them crashing as customers withdraw orders.
Of course, there is an even bigger source of uncertainty that lowers earnings quality. Simply put, accepted accounting rules give companies a lot of wiggle room about when to record a sale as revenue. And when management needs an extra few hundred million of revenue, booking sales in advance is often too hard to resist. But the temptation ultimately catches up with a company.
Fools know that unusual changes in accounts receivable -- the line on the balance sheet that states what customers owe -- is a telltale sign of trouble. The company has booked the revenue, but has yet to collect the cash from the sale. An increase in receivables is indicative of trouble collecting from customers or extending credit to customers of poor credit quality, which may be the case in a weak economy.
Auto maker Ford
Then there are "one-time" charges that deteriorate earnings quality. Some companies' earnings raise investor eyebrows more than others. Broadcom, for instance, said that it earned $61.3 million, or $0.19 per share, in the fourth quarter. But when a slew of charges were included, it achieved only $6.1 million. Eastman Kodak
To be sure, no company has perfect earnings. But look for businesses that are achieving their earnings growth without reliance on one-time events, trends outside their control, and aggressive accounting. This leads to an interesting speculation: The high P/E multiples at high-quality-earnings companies such as Dell, Microsoft, GE, and Wal-Mart could -- at least in part -- be justified.
Motley Fool contributor Ben McClure hails from the Great White North. Ben doesn't own any shares mentioned here.