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 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 software
Here are the top two and bottom two companies in my quality-of-earnings screen.

Top quality of earnings

Company

5-Year Revenue Growth

TeleCommunication Systems (Nasdaq: TSYS)

 37.7%

Lawson Software (Nasdaq: LWSN)

17.0%

Bottom quality of earnings

Company

5-Year Revenue Growth

MicroStrategy (Nasdaq: MSTR)

9.8%

Tyler Technologies (NYSE: TYL)

11.3%

These software 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 software companies above is an inadequate measurement of evaluation.  Our earnings-quality screen (along with a decade of corroborating evidence!) suggests that TeleCommunication Systems and Lawson Software are our buy candidates and that MicroStrategy and Tyler Technologies 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. 

John Keeling has no position in any company mentioned. 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.