Most recently, the discussion about earnings quality increased significantly. It is fair to say that popular growth stocks, for example LinkedIn (NYSE:LNKD) and Twitter (NYSE:TWTR), fueled this discussion. Several articles were published, questioning Twitter's and LinkedIn's earnings quality due to extremely high share based compensation expenses. I believe that earnings quality is an important factor to consider before making an investment. In this article, I will explain what earnings quality is, how it is measured, and why earnings quality is important for investors. Finally, I will analyze the earnings quality of Coca-Cola (NYSE:KO), a well known and popular dividend growth stock.
In my opinion, Coca-Cola is a great stock to own (see this previous article). Coca-Cola delivered strong and stable results over the past years and I expect that the company's earnings quality is high. This article contributes to an increasing understanding of Coca-Cola's earnings quality in order to make a better investment decision for this stock.
What is earnings quality and how is it measured?
Earnings quality is hard to define. Many academics have a slightly different definition of earnings quality. Basically, it comes down to the ability of reported earnings to reflect the company's true earnings. In case of good earnings quality, investors should be able to predict the company's future earnings and make a reliable calculation of the company's value. From this perspective, earnings quality is important for investors. I will discuss the importance of earnings quality later in this article.
As earnings quality is hard to define, it is even harder to measure. The New York State Society of Certified Public Accountants (NYSSCPA) noticed an interesting model, supported by the Financial Accounting Standards Board (FASB). First, the NYSSCPA refers to eight different models to measure earnings quality. However, all eight models have very narrow windows and do not cover a full analyses of earnings quality. To come up with a more complete assessment, twenty criteria (including ten overlapping criteria) were selected into one model.
The model measures earnings quality by twenty relevant criteria on a scale from 1 to 5. The selected criteria are assumed to cloud the company's true earnings and/or to be potential indications for active earnings management. The criteria are selected out of eight different models to measure earnings quality and, therefore, the model is very complete. Based on the final score, earnings quality is qualified as excellent, good, fair, marginal and poor. To measure earnings quality, I will evaluate a company's financial statements based on this model.
Why does earnings quality matter for you as an investor?
In one of my previous articles, I mentioned this study by George Akerlof (1970). Akerlof researched the market for used cars and he found that there is a significant statistical connection between the level of uncertainty about a product's quality and the price that buyers were willing to pay. The more signals buyers received that pointed at a low quality car (for example, no maintenance history and a high risk for defects), the lower buyers actually paid for that car. You might think, this is a study of used cars, why should I even bother? However, Akerlof's study is more than relevant for the stock market and for investors as well.
When considering to invest in a stock or not, investors will probably weigh the risk of the investment in relation to its potential return. In case investors receive a signal that compromise risks and uncertainty about a stock, they are probably willing to pay a much lower price. In some cases, the risks and uncertainty about a stock are clear, for example when a company commits accounting fraud. I recently wrote this article about Royal Imtech (OTC:IMTEF), a small-cap technical service provider. This company is engaged in an accounting fraud scandal and now its future is very uncertain. The risks associated with this investment are very high and, therefore, the stock trades at a steep discount.
In other cases, the risks are less clear, for example, in case of poor earnings quality in financial statements. If earnings quality is poor and undetected, investors are likely to make wrong projections regarding the company's future earnings and its value. If investors had noticed poor earnings quality and the risk of making wrong projections, they would be likely to lower the valuation for the company. As a result, investors should consider earnings quality in case that they base (a part of) their investment decision and/or future earnings potential on the company's historical earnings.
One of the objectives of FASB's Conceptual Framework is to assist investors in making investment decisions, which includes predicting future earnings. The Conceptual Framework refers not only to the reliability (or truthfulness) of financial statements, but also to the relevance and predictive ability of information presented in financial statements.
How do Coca-Cola's earnings hold up from an earnings quality perspective?
Now, let's see how all the theory above hold up for Coca-Cola's earnings quality. As I mentioned before, I will use this model to evaluate earnings quality. I ranked the twenty criteria from 1 to 5 in the table below and disclosed several notes to provide additional information and background for the ranking of those particular criteria.
|Gross margin/sales ratio||4||(1)|
|Cash flow exceeds net income||5||(3)|
|Pension expenses and gains||3||(5)|
|Stock option expense||3||(6)|
|Gain/loss from asset sales||4|
|Ongoing restructuring charges||4|
|Reverses prior charges||5|
(2) Very low earnings variability over the past three years, plus stable earnings per share.
(3) Cash flow from operation activities exceeded net profit over the past three years.
(4) Operating leases around $1,000 million over the past three years or 2.20% of total revenue.
(5) Volatile pension charges and changes of pension liability. Although, this is not an unusual amount compared to the industry.
(6) 56 million shares granted in 2013 for around $37/share.
(7) No assets held for sale on December 31, 2013 compared to $2,973 million on December 31, 2012. Somewhat volatile.
(8) Stable around 24%. Still, the tax rate is lower than average U.S. Corporate Income Tax rate of 35%. Potential charges in the future. The industry's overall effective tax rate is higher as well.
(9) Large buyback program in place.
I find that Coca-Cola scores 82 points out of 100. According to the score model, Coca-Cola's earnings qualify as 'Good'. It is important for investors to find out that Coca-Cola's financial statements have good earnings quality, because predicting future earnings based on historical financial information makes much more sense if Coca-Cola has good earnings quality.
Based on the valuation model and my findings in the table above, I qualify Coca-Cola's earnings quality as 'Good'. In fact, Coca-Cola's score is in the upper level of this category and almost qualified as 'Excellent'. This means that earnings quality of Coca-Cola's financial statements and reports is reliable and that investors can rely on historic earnings to predict future earnings. Following Akerlof's theory regarding risks and uncertainty versus price, investors are likely to pay a fair price for Coca-Cola shares. My findings could also help investors to make a sound calculation of Coca-Cola's value and, as a result, make a better investment decision.
Disclosure: The author is long KO.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.