Understanding what lies beneath a company's reported revenue is a key to finding winning or losing stock ideas. Many investors screen on metrics such as net income or related measurements such as EBIT, EBITDA, or operating cash flow. Revenue, profitability, and cash-flow growth equal opportunity, right? Well, not necessarily. Companies know that Wall Street closely monitors these factors, and they therefore do their level best to provide a good story for investors.

Quality of earnings is what matters
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, by 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 you can use is to measure operating cash flow minus net income.

In a series of articles looking at whether quality of earnings can help us find the buys and shorts within an industry, I'm going to test how well this shortcut works. I'll look only at companies with five-year annualized growth rates of better than 5%. 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 communications computers and peripherals
Here are the top two and bottom two companies in my quality-of-earnings screen:

Top quality of earnings


5-Year Revenue Growth

Imation (NYSE: IMN)


Novatel Wireless (Nasdaq: NVTL)


Bottom quality of earnings


5-Year Revenue Growth

Hypercom (NYSE: HYC)


Intevac (Nasdaq: IVAC)


These computer and peripherals companies are in the information technology sector. Let's look at how companies in this area have performed over the past decade when ranked by my simple quality-of-earnings metric.

The graphs tell the story
Companies with higher quality of earnings significantly outperform those with lower quality of earnings. Quantile 1 stocks (with the highest earnings quality) generated more than 20% annualized returns, while Quantile 5 stocks (those with the lowest earnings quality) returned about 0% (zilch!) over the same time period.

Clearly, the revenue-growth story for the computers and peripherals companies above is an inadequate measurement of evaluation.  Our earnings-quality screen (along with a decade of corroborating evidence!) suggests that Imation and Novatel Wireless are our buy candidates and that Hypercom and Intevac Systems might 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 shortcut, though. 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 for free right here, or you can enter your email address in the box below.