Quality of Earnings

Earnings Quality is a term that is frequently used by investors, business analysts and operators. But what do we mean by earnings quality? Is it an accounting definition, an investment concept or maybe a little bit of both? How should we measure the quality of earnings? Does quality relate to the sustainability of earnings? Or is it stability? Or maybe the ability to grow earnings in the future?

Investing is often discussed from the vantage point of principles. And from when viewed through principles, investing seems pretty simple. You buy when assets are cheap, you sell when assets are expensive. Simple.

Soccer legend Johan Cruyff is known to have said that football is a simple game, but playing simple football is the hardest thing there is. Just as in football, it turns out that when we attempt to apply all those crispy investment principles we pick up from the likes of Warren Buffett or Benjamin Graham, the devil is more often than not, in the details. .

Once you start applying your valuation methods, once you start doing your research, reading your 10-Ks and 10-Qs, you may often find yourself – to borrow from the Jesuits – descending from the principles and into the particulars. Before we buy cheap, we first need to define cheapness. And in the world of investing, what seems cheap is often expensive and what seems expensive is often cheap.  

The concept of Earnings Quality is an apt example. According to Wikipedia, Earnings Quality is an accounting term. It refers to the ability of reported earnings (income) to predict a company’s future earnings. By analysing a company’s financial statements, you should be able to get a feeling for how stable that income is.

What this means is that you can look for red flags that might indicate that the company is aggressively accounting for earnings. You could, for example, look at one time charges that boost earnings, unusual changes in accounts receivables or differences between capital expenditures and the rate of depreciation. 

The financial statements can reveal red flags about dubious accounting practices, but for a business analyst it would be naive to think that the financial statement alone will tell the whole story about how sustainable a company’s earnings are. Many things happen outside of the financial statements. 

Conventional Views on Earnings Quality

When people in finance and investing talk about the Quality of Earnings of a particular company, in most cases they are not talking from a pure accounting perspective. The quality of the business might be expressed in the financial statements, but the determinant will be through the business model of the company. 

How does the company create value? How does it capture value? How much of the captured value actually ends up with shareholders? How defensible is the business model? By what means can it grow? These are all fundamental questions that you need to ask yourself to understand the key drivers of earnings and cash flows.

In fact, Quality of Earnings might not even be the appropriate term for this. Perhaps we should be talking about Qualities of Earnings. Some business models generate a lot of free cash flow but have limited potential to scale. Others generate earnings but require cash to grow. Some business models have defensibility, thus sustainable earnings. Others have increasing marginal return and require growth to reflect the quality. 

If you are going to define the earnings quality of a given company, you will need to have, at least, a general understanding of its business model. Because, as we will discover later, not all earnings are created equal.

A Primer on Earnings

Earnings are the income a company generates for its shareholders. You will find Earnings of a company on its income statement. It should tell how profitable a company is over a given period.

One of the 5 main principles in accounting is the matching principle of accrual accounting. In other words, you match the expense of the input with the revenue earned from the sale of the output. What this essentially means, is that when you read an income statement, you are reading an attempt to accurately reflect how much it cost to generate the recognized revenue of a business, within a specific period of time.

Readers with an accounting background will note that reported earnings will not always fully reflect the true profitability of a company to its shareholders. Hence, a company can be very profitable without showing any earnings. Inversely, a company can report high earnings, without actually being profitable. 

For instance, in certain industries and for certain business models, there is a significant difference between earnings and cash flows. A profitable company can be consuming cash, while a company that does not show a dime of earnings, can be gushing out cash to its owners. A good example of the latter is the case of John Malone and the TCI.

The problems for you as a business analyst don’t end there. In the Wikipedia definition above, it said that the Quality of Earnings was the ability of reported earnings (income) to predict a company’s future earnings. But earnings are a shareholder return metric and there is a long way from a company’s operating income to its shareholder earnings. 

The capital structure of a company will have an effect on earnings. For this reason, when you are analysing a business, you need to separate income of the operations of a company and how that income flows to different securities in the capital structure (equity, preferred equity, debt, etc). Du Pont analysis is a method for doing this. 

For this reason, business analysts usually do not use earnings but adjusted metrics like EBITDA, EBIT or NOPAT to compare companies. This removes the effect caused by the capital structure and presents a more apples-to-apples comparison of competing companies.  

Enter Owner Earnings

The problems with the matching principle mentioned above and the distortions it can create does not end there for the analyst. As a business analyst, you have established that depreciation on the income statement reflects the historical costs, which might not reflect the replacement cost of those historical investments. 

Nonetheless, companies aren’t static constructs. They continuously scrap projects and enter into new ones. So, when we need to figure out how much of the capital expenditures are to maintain current operations. If you can do that, you can paint a picture of the sustainability of the earnings. 

Warren Buffett, who is arguably history’s most successful business analysts, calls this Owner Earnings. In 1987, he laid out this simple formula to determine the actual free cash flows that end up with common shareholders: 

  1. Reported Earnings
  2. Less Depreciation and Amortization
  3. Plus Capital Expenditures and Working Capital additions required to maintain current earnings

Note that a company might be investing in new growth projects, so not all of the capital expenditures might be invested to maintain current earnings. A business analyst would need to estimate how much of CapEx and Working Capital additions are meant for growth and how much is meant for the maintenance of current operations. 

The financial statements will give the analyst an idea of history, but the true value of the business is determined by its future cash flow. And here, the analyst faces yet another problem. 

The Present Value of Future Cash Flows

To a business analyst, the problem is not just the difference in timing that causes a problem. On the income statement, the recorded earnings are determined by the cost of generating the stated earnings. But the job of the analyst is to determine the value of the company based on future cash flows and to do that he needs to account for the time value of money.

The problem of Time Value of Money is not a new one. It’s a puzzle people have been trying to solve ever since Aesop determined that he prefered a bird in hand over two in the bush. Using Discounted Cash Flow as a valuation method for stocks gained notoriety with Irving Fisher’s book Theory of Interest Rate. 

Scalability According to Finance People

In most scientific disciplines, the concept of scalability describes how things keep their properties or application at a different scale. When business and finance people talk about how things scale, what they mean is how business models become more profitable at bigger scales. 

In business, scalability is often associated with the business models enabled by the internet. People think of the Microsofts, Amazons and Googles of the world. But ingenious entrepreneurs and business people have been coming up with scalable business models long before that. 

The essence of a scalable business model is that the capital requirements per unit of output diminish with each new output. Ray Kroc would not have been able to grow McDonald’s as fast if not for the franchise business model. He effectively leveraged other people’s capital. 

Having Customers that Stick

As an analyst, you know that:

  1. Historical costs do not necessarily reflect future costs 
  2. The value of a company or a security is determined by its future cash flows, and
  3. Future Cash Flows need to be discounted to its present value

But there is a piece missing in this equation. It’s not actually missing, but rather hidden within point 2) and 3). Even if you understand how the business model scales, you will never know how it actually scales until after the fact. 

In recent years, metrics such as Customer Acquisition Cost, Customer Lifetime Value, Churn Rate and Contribution Margin have become popular topics in investing circles. These metrics help us determine how sticky earnings or reliable current and future earnings are. 

Not all Earnings are Created Equal

Martin Whitman, a value investor whose writing I admire greatly, recognized four distinct ways that a company creates value:

  1. Access to capital markets at favourable rates
  2. Resource conversions, namely through asset redeployments or change of control
  3. The creation of earnings while consuming cash
  4. Cash flow streams available to security holders

In the first two items, value is unlocked through the balance sheet as assets or liabilities go through re-valuations (or are replaced). The latter two types, however, concern value creation that shows up on the income and cash flow statements.

According to Whitman, most companies create earnings while consuming cash as opposed to streams of free cash flow. This is not a binary option, however, but more of a spectrum.

An example of business at the far end of the spectrum of companies that consume cash generate earnings would be conventional retail businesses. To generate sales the retail business requires resources for sales and marketing as well as inventory. To increase revenues, the business must spend on inventory and/or marketing and sales efforts.

On the other end of the spectrum, you have income streams that require no reinvestment. One of the best examples of this type of income is a royalty stream. Companies that collect royalties, usually have limited influence on the propensity of the stream.