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Book Review: Quality of Earnings by Thornton O'glove

 The Quality of Earnings by Thornton O’glove highlights the profitable insights that the average investor can derive from reviewing a company’s publicly-disclosed financial statements like the 10-K, an annual filing, and the 10-Q, a quarterly filing.  The book focuses primarily on the analysis of the 10-K and 10-Q.  While reviewing a company’s financial statements is only one perspective of investment research, these filings are loaded with useful information that can help one understand a company’s potential of increasing/decreasing earnings in the future.  O’glove introduces the novice and reminds the professional investor of the value that can be found in these filings.  The writing and examples throughout the book are very clear and easy for most readers to follow.  Readers with little accounting knowledge will be able to follow most of O’glove’s writing.  While the book tends to focus on spotting and avoiding troubled companies, the discussed techniques and analysis can be used by investors to find potentially strong investments. Even though the book was written in the 1980s and some of the companies used as examples may be unfamiliar to younger investors, most of the tools and analysis are timeless.

The reader should understand that this book operates largely under the assumption that a company’s stock price will eventually reflect that company’s operating results.  Yet, as mentioned in the book, this does not always occur.  For instance, there are several companies that O’glove describes as having poor operating results and that he advised investors, at the time, to avoid; however, these companies were subsequently acquired by other companies at premiums to their original stock price.  Such events are a cost of doing business in the equity market and a risk incurred when shorting stock.  In some instances the operating results of a company will be ignored by the market.  Nevertheless, these methods should not be ignored if one believes in investing in healthy companies and avoiding potential losses, while understanding where management could be manipulating operating results.

The first four chapters of the book are very much geared to the novice investor and reveal the various motivations and deceptions that exist in the professional investment world.  The key message is that investors need to be skeptical of financial news, financial experts, newsletters, analyst research, auditors, and company management.  Basically, skepticism of every medium involved in conveying financial information is healthy.  In general, these parties have much more to gain by conveying bullish messages to the market, than bearish messages.  These conditions still remain in the market today.  As a result, many times information and analysis may not be as objective as investors would prefer.  The investor has very little to lose by being skeptical.

After providing the investor with sufficient reasons to be skeptical of the many financial information mediums, O’glove dedicates the remainder of the book to demonstrating the use of several analytical tools and methods that can glean profitable information from company financial reports.  These methods, while simple, are very useful and easy to utilize.  O’glove then discusses, in-depth, the analysis of: (1) nonoperating and/or nonrecurring income items; (2) declining and increasing expenses; (3) shareholder reporting versus tax reporting; (4) accounts receivable and inventories; (5) debt and cash flow analysis; (6) accounting changes; (7) dividends; and (8) big bath accounting.

O’glove spends considerable emphasis on analyzing accounts receivable and inventories.  He believes that these two accounts have the most potential to predict a change in future earnings for either the positive or negative.  His techniques are simple to use and effective.  Yet, if the company one is analyzing is a service company, then analysis of inventory is of little use.  Consequently, in the book, all of the examples for inventory and accounts receivable analysis consists of retailers and manufacturers.

Of all the analysis topics discussed above, the one that the novice would have the hardest time understanding is shareholder reporting versus tax reporting.  O’glove makes an honorable attempt to make this topic comprehendible to those with little accounting background, but does not fully explain the nuances behind the differences behind shareholder reporting and tax reporting.  He is unable to explain why these differences occur or how they occur.  Instead, O’glove’s recommendation to the reader is if shareholder reporting and tax reporting differ significantly, or if that difference is growing, then that is a warning flag that future shareholder earnings may diverge from the existing trend.  Basically, additional reading will be necessary by the reader to fully understand O’glove’s tax reporting methods.  Nevertheless, looking at the tax reconciliation footnote in the 10-K is highly recommended for all companies.

Furthermore, O’glove’s section on cash flow analysis has room to be more detailed.  This section largely is irrelevant due to changes made in the Generally Accepted Accounting Principles since the book was published.  Since 1987, companies are mandated to provide a Statement of Cash Flows in their financial statements.  The majority of the chapter consists around determining the cash flow from operations in the manner that is now used in the Statement of Cash Flows.

This book has plenty of information for both the novice and the professional; however, it benefits the novice a great deal more than the professional.  All the topics O’glove discusses have many more factors and details than he touches upon in his book, but his book sets a helpful foundation loaded with examples for the reader.  He provides helpful tools any investor can use to thoroughly and efficiently analyze key data in public company filings. Moreover, at present, any investor can replicate O’glove’s methods as detailed in the book by: (1) going to the website of a prospective investment and downloading the financial filings from the investor relations section; (2) going to www.edgar-online.com for free financial filings; or (3) subscribing for a reasonable fee to www.10kwizard.com.