Understanding what lies beneath a company's reported revenue is a key to finding winning or losing stock ideas. Many investors screen on metrics like Net Income or related measurements such as EBIT, EBITDA, or Operating Cash Flow. Revenue, profitability, and cash flow growth equals opportunity, right? Not necessarily. Companies know that Wall Street is closely monitoring these factors, and do their level best to provide a "good story" for investors.

Quality of earnings are what matter
Investors can get a much better picture of a company's revenue or cash flow story by also looking into the quality of earnings. Ideally, you can play the role of forensic accountant, reading all of a company's SEC filings and financial statements in search of accounting tricks that might tend to mask deteriorating company performance. Or one powerful shortcut that you can use is to measure Operating Cash Flow-Net Income.

I'm going to test how well this short cut works in a series of articles that look at whether quality of earnings can help us find the buys and shorts within an industry, looking only at companies with 5-year annualized growth rates >10%. I'll then rank companies by my quality of earnings metric, normalized to account for companies of different sizes: (Operating Cash Flow – Net Income ) / Market Cap.

Finding the longs and shorts in retail
Here are the top two and bottom two companies in my quality of earnings screen:

Top quality of earnings

Company

5-Year Revenue Growth

Bon-Ton Stores (Nasdaq: BONT)

18.4%

Dollar Tree (Nasdaq: DLTR)

11.4%

Bottom quality of earnings

Company

5-Year Revenue Growth

GameStop (NYSE: GME)

35.6%

hhgregg (NYSE: HGG)

15.2%

These retail companies are in the Consumer Discretionary sector. Let's look at how companies in this sector have performed over the last decade when ranked by my simple quality of earnings metric:

The graphs tell the story
Higher quality of earnings companies significantly outperform lower quality of earnings companies. Quantile 1 stocks (with the highest earnings quality) generated nearly 18% annualized returns, while Quantile 5 stocks (lowest earnings quality) returned about 7.5%.

Clearly, the revenue growth story for the retail companies above is an inadequate measure to evaluate these companies. Our earnings quality screen (and decade of corroborating evidence!) suggests that Bon-Ton Stores and Dollar Tree are our buy candidates and GameStop and hhgregg might potentially even be shorting opportunities. Of course, before pulling the trigger, investors should do their homework to get an even better and more comprehensive picture of quality of earnings and earnings growth.

Finding companies to short using a quality of earnings screen will take more than my simple quality of earnings shortcut. That's why John Del Vecchio, CFA, a leading forensic accountant and The Motley Fool's shorting specialist, put together a detailed report that shows you how to spot five serious red flags that can help you detect time bombs in your portfolio and lead you to the next big short. You can get the entire report free by clicking here or by entering your email address in the box below.

John Keeling has no position in any company mentioned. Motley Fool Options has recommended writing covered calls on GameStop. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.