Earnings Quality: Why It's So Important Now and Which Stocks Are Suspect

EQ is important in this current market environment because so many companies are feeling pressure to meet their sales expectations. Many companies are channel-stuffers, which is one form of accruals that often leads to negative earnings surprises. A recent poster-child for this example of sending excess inventory to stores that could not sell its products would be Crocs (CROX) and the way the company tried to pad its sales numbers.

Earnings Quality: Accrual

• An accrual is the difference between Cash Flow and Net Income.
• Net Income = Cash Flow + Accruals
• Low Accrual companies outperform high accrual

There are two ways to approach accruals:

1. Cash Flow Statement

• Difference between Net Income and Cash Flow

2. Balance Sheet

• Change in Net Operating Assets from Period t-1 to t
• Net Operating Asset equals Total Assets Less Cash, Less Non-Debt Liabilities (excl. Minority Interest)

Our studies show that the Balance Sheet approach is superior to the Cash Flow Statement approach.

We found the Balance Sheet approach is also easier to expand to international companies.

We screened the S&P500 to identify those firms with the worst EQ scores. The score is given from 1-100, 1 being the best EQ company, 100 being the company with the highest amount of accruals and the worst EQ. Because high EQ companies are more likely to have negative earnings surprises, this is a group of companies you may want to avoid. The EQ variable works well as an exclusionary variable coupled with AFG’s valuation model.

After running our screen we identified 19 firms as the worst Earnings Quality firms. You can set yourself up for success and save time by narrowing your list of constituents to only those that meet our standard valuation, Economic Margin and Management Quality checks and following that up by filtering out those companies most likely to have negative earnings surprises (high EQ). The Chart Below identifies the firms that met our screen criteria, along with the EQ score and our VE analysis.

Worst 10% Earnings Quality Companies In the S&P 500

Universe Size: 4,000 to 5,000 Firms

Source: Applied Finance Group Database from 9/1998-5/2008

This variable does not add any value for companies within the financial sector and those companies are automatically screened out when using this variable.

Comments

[ashman:]

this is an interesting analysis but doesn't this apply to product companies more than service companies? Nasdaq isn't shipping anything to anyone or stuffing shelves they perhaps just are a bit more generous with payment terms and hence the accruals but their customer leverage is so high (delisting for unpaid bills) that they can afford to be a bit more relaxed on terms......just my thoughts......

2008 Dec 03 07:23 AM

[long_on_oil:]

If I have learned anything during my 35 year investment life, it is you can not trust the income statement or balance sheet of ANY corporation. I learned this lesson in spades the past year. We are now finding Enron is becoming the rule, not the exception. I was dumb enough to actually believe the SEC has protecting my interest at heart.
The worse part of this entire lesson is now that my investments have been halved, if I were to sell the rest, where would I put the money. I could buy Gold but that would only guarantee that gold would go to $500....lol

Another thing I have learned is that the author of this article is correct but you also have to watch one other thing on the balance sheet and that is inventory. Companies can adjust their earnings by increasing or decreasing the value of their inventories. This adjustment effects earnings by only pennies but sometime 1c is all that is needed to meet expectations.

2008 Dec 03 09:08 AM

[oldman:]

worthless.

2008 Dec 03 09:11 AM

[sumosama:]

Cash flow doesn't lie...well, didn't used to...

2008 Dec 03 10:32 AM

[MILESCFA:]

Is PWND reference suppose to be NDAQ!!!!!!!!!!!!!!!!!!...

2008 Dec 03 12:24 PM

[gobears:]

The author does not so state, but it would seem that he is not after the total amount of accruals, but the ratio of accruals to cash, or accruals to the total of accruals plus cash. Perhaps the author can confirm this

2008 Dec 03 04:06 PM

[User 317865:]

I am sure Boeing shipping out excess inventory!! To whom? Most of their products are build to order. The opening paragraph should have been written better. Boeing most likely has a poor EQ score becuase they are mostly accuring the sales before delivery.

2008 Dec 11 07:18 PM

[A Common Woman:]

I like the idea of trying to get behind the numbers. As a former manager of construction loans, I can tell you that any commercial contractor who hits his projected numbers to the penny is lying. I don't see why people imagine that large companies, with multiple projects, should hit their numbers either. However, this analysis seems too simple. If what we are looking at is the difference between net income and net operating assets, not including cash, then a change in EQ can be a sign of acquiring bargains, of refinancing, of investment in research and development, or of a company that is thick in …cash!

Apr 23 04:51 PM