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.

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 Securities and Exchange Commission 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 shortcut 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 average yearly growth rates since 2005 greater than 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 restaurant and leisure stocks
Here are the top two and bottom two companies in my quality of earnings screen:

Top quality of earnings

Company

Average Revenue Growth Over Past 5 Years

Quality of Earnings Metric Value

Cedar Fair (NYSE: FUN)

12.55%

11.69

Pinnacle Entertainment (NYSE: PNK)

16.63%

10.24

Source: Capital IQ, a division of Standard and Poor's, and author's calculations. Figures are the average of five one-year growth rates since 2005.

Bottom quality of earnings

Company

Average Revenue Growth Over Past 5 Years

Quality of Earnings Metric Value

Caribou Coffee (Nasdaq: CBOU)

10.73%

(1.67)

Ambassadors Group (NYSE: EPAX)

15.41%

(6.92)

All of these restaurant and leisure 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:

G

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 restaurant and leisure companies above is an inadequate measure to evaluate these companies. Our earnings quality screen (and decade of corroborating evidence!) suggests that Cedar Fair and Pinnacle Entertainment are buy candidates, and Caribou Coffee and Ambassadors Group might potentially 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 hereor by entering your email address in the box below.

John Keeling has no position in any company mentioned. The Fool owns shares of Ambassadors Group. 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.