Earnings Quality

Here’s an article I read in MyPaper January 11, 2010 in Singapore. It is titled ‘Why all earnings are not equal’—an interview with Robert Olstein (Olstein All-Cap Value Fund) by Gretchen Morgenson for New York Times (I suppose NYT means that =P ).

And I find this a coincidence. I was recently speaking with Jackson, an friend of my sister. And he was talking to me about investments (more like me picking his brain). One of the things he mentioned is earnings quality.

Earnings (and profits) is just a number. It can be manipulated, defined, reviewed, re-defined, rounded off, obscured, obsfucated, etc. The information and the source of this earnings define its quality.

One of the most common example:
You take a look at the earnings of a company, and you see that this year there’s quite a sharp increase in earnings. This would look out of place when compared to previous years. So, you read the annual report/news in more detail and found that the company has just sold an asset (a building, land, factory, its operations, a subsidiary, etc). This means that this year’s earnings does not reflect the true business earnings. This is nothing bad. The analyst just needs to be aware.

Another type of obsfucation is the EBITDA. EBITDA = earnings before interest, tax, depreciation & amortization. Amortization = depreciation of non-tangible assets. I think it is bullcrap. All I know is that it does not reflect the actual earnings (or profit) of the company, and it’s useless except for obsfucation. Apparently, it is used by tech companies because they typically have very high cost of operation. And EBITDA is used to give a positive effect. Pffft…

The 2 scenarios below are sneakier. But can be easily spotted by checking the disparities between its earnings and its excess cash flow.

1. from Vincent (wshiong.blogspot.com)
The articles mentioned that this disparity can show up in the ways companies account for capital expenditures. Certain assets in a company can depreciate over the years. To increase the earnings (& profits), a company can manipulate the amount of depreciation. For example: KNM listed in Bursa Malaysia. Apparently, in order to plump up its earnings, it changed the depreciation of its assets from 99 years to 999 years. This would reduce the annual depreciation, and thus increase the earnings.
I told you these guys are sneaky. The article says: “One way to assess the accuracy of management’s estimates is to compare, over time, how much a company spends on new plant and equipment and how much it deducts in depreciation each year.”

2. from Jackson
A company (lets call it Company A) can also sign an agreement with another company (Company B). The agreement says that Company B agrees to buy 100k of products from Company A. Since this is considered a business done, it is listed in the earnings report as receivables. However, this deal is done near the end of the financial of Company A. And once the financial year is over and annual report done, they will terminate the agreement.
However, this ‘transaction’ will show up in the cash flow as a discrepancy because the amount received does not match the earnings. I mean, seriously, Company B wouldn’t be that crazy to actually give Company A money for a fake show.

For conclusion,
I’m gonna quote the article:
Some of the discrepancies that emerge can be temporary, cased by the lag time between an initial investment and subsequent write-downs for depreciation.

Companies in a growth phase, for instance, will show greater capital expenditures than depreciation as they increase investments in plant and equipment.

Consistent gulfs between capital spending and depreciation should concern investors. “You have to reconcile the differences, or the market will do it for you.”


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