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Wednesday, 9 July 2014

Earnings Season Warning: High Quality Earnings Still Matter

As the U.S. stock market is at or near all-time highs, having surged past the previous highs from 2007, there is now increased pressure on companies and management to hit or surpass the widely publicised estimated EPS to support the share prices. Some will exceed these forecasts by some margin, some will just hit them while others are scrambling to hit them. Others will fall way short.

The time is now ripe for accounting creativity. For some companies, the temptation to reduce those reported costs and increase reported sales is now as high as ever. This is why investors should read the reported accounting numbers with the utmost skepticism and spend perhaps even more time than usual scrutinising them. Are sales and profits surging while the asset turnover ratio is declining? Are allowances for bad debt in percent of sales and aged debtors (accounts receivable) dropping? Is the company depreciating assets over a longer period? Are cash flows from operations and free cash flow falling, even as the company has not made any major investments, while earnings are rising rapidly? These are some warning signs to look for which might indicate companies are indeed cooking their books resulting in lower quality earnings. Make sure you read through the tedious notes and accounting policies section and read the auditors statement and the management discussion and analysis chapter. Count the number of times the word "challenging" is used in the quarterly report - many mentions could be a really bad sign.

If you are suspicious the numbers are not conservative enough, then make your own adjustments to the numbers before you conclude whether the company is a good buy or not. If you think the numbers reported are too good to be true, they might just be, especially this time around. High quality earnings still matter and they probably will mean a lot more again in the near future. And as always, and all else remaining the same, a company reporting high quality earnings should sell at a premium to a company with low quality earnings.