Conservatism Leads to Higher Share Prices

The phrase earnings quality is a bit of a misnomer. How is one dollar of earnings any better than another dollar? And isn’t quality subjective anyway? In last Wednesday’s issue of Small Cap Investor Daily, Finding Diamonds in the Rough, I said that in a future issue I would review two fundamental analysis metrics, earnings quality and cash flow. Today I’m digging in to the meaning of earnings quality so that you can put this fundamental analysis metric to work uncovering small-cap gems to add to your portfolio.

When I talk about earnings, I’m often referring to earnings per share (EPS), which is net income divided by the number of shares outstanding. Sometimes net income is referred to simply as profit, or even just as earnings.Simply put, earnings are a company’s net profits from operations. There are three sub-totaled line items on an income statement that you should look at:

1. Net income from operations (operating net income): This is the calculated profits including all revenues, minus direct costs and expenses related specifically to the core business. It usually excludes nonrecurring, or noncore sources of income, but history has demonstrated that some companies use a loose interpretation. More on that in a minute.
2. Net pre-tax income: This adds other income and subtracts other expenses from operating income, but it does not include the liability for income taxes. Typically, these adjustments include interest income and expense, currency exchange profit or loss, capital gains and losses, payments or receipts in settled or finalized lawsuits, and other nonrecurring, non-core transactions.
3. Net income: This takes the net pre-tax income and deducts the liability for federal income taxes (state and local taxes are already deducted in the expense section of the report). The tax hit can be a big number. As of 2009, corporations can be required to pay up to 38 percent of their net income in federal taxes.

Depending on the company you’re looking at, certain income items may be worth special consideration. For example, in last Friday’s issue of Small Cap Investor Daily, The Gig is up – This Stock’s a Winner, I reviewed Lancaster Colony (Nasdaq: LANC). Lancaster has a history of receiving cash distributions under U.S. anti-dumping law. This income is accounted for as ‘other income’, and not included as part of operating income.

So when it came time to evaluate Lancaster’s revenue and earnings growth I highlighted the fact that excluding these distributions gave a better picture of Lancaster’s true business growth. And to show how important the difference can be, I found that Lancaster actually increased net margins to 12.7% over the last year. If I didn’t break out the ‘other income’ cash distributions, it looked like the profit margin was just 7%.

That 5.7% difference in margin is greater than Wal-Mart’s (NYSE: WMT) historical profit margin, which hovers around 3.5%. The fact that Wal-Mart has built one of the most successful companies of all time by operating on razor thin profit margins should be enough to convince most investors that taking a close look at earnings is critical.

This brings us to the discussion of the quality of earnings, a subjective measure for sure. Especially since management has some control over its accounting methods (so long as it complies with Generally Accepted Accounting Principles - or GAAP).

When it comes to the quality of earnings, we’re trying to understand how reasonable the earnings stream actually is and how sustainable earnings will be in the future. Since all companies generate revenues from different sources we want to look at the underlying economic realities of those revenue streams. That will help us determine the real viability of the company’s business model.

So the big question is: will the company be able to create a positive revenue and earnings trend, and continue that trend into the future? Of course there is a limit to earnings as a percentage of revenue. It’s realistic to expect a company can maintain a consistent profit margin, or even grow that profit margin over time.  It is less realistic to expect the percentage to continue to increase every year indefinitely. Given the inescapable increases in cost of goods sold and expenses, there is always a reasonable limit to profit margins. For most investors, it is glowing enough when management can report consistent net income margins while revenues rise each and every year.

I mentioned that some companies use a loose interpretation of earnings. That’s because even within GAAP, there is a fair amount of flexibility. Just like on your personal tax return, there are various degrees of conservatism or aggressiveness. But generally speaking, the more conservative a company is with respect to its reported earnings, the higher the quality of earnings is.

So let’s take a look at the difference between high-quality earnings and low-quality earnings. High-quality earnings are the product of conservative accounting practices that provide a clear and reliable picture of the company’s financial status. You spot high-quality earnings in several ways:

• The trend in earnings is growing consistently over many years
• Earnings track growth in revenues consistently, without questionable increases in earnings that exceed the rate of revenue growth
• A company with high-quality earnings tends to gain market share within a sector, indicating that those earnings are accompanied with a strong core business
• The dollar level of earnings increases each year, and the net return, or net profit margin, (percentage of net earnings/net profit to revenues) remains consistent or grows over time.

Low-quality earnings are just the opposite—earnings that have been buffed up through liberal accounting procedures that, in turn, do not portray the company in a fully accurate light. Some symptoms include:

• High volatility, with earnings increasing and decreasing each year
• Unexplained variation in the net return over time
• Big core earnings adjustments to reported net earnings
• Disparity between reported earnings and the PE ratio, when the number of outstanding shares has not changed. This could mean earnings are being manipulated just to favorably impact the price of shares
• Significant one-time expenses that regularly distort the performance of the business

There is a lot of analysis you can do when it comes to evaluating the earnings quality of a potential investment. But this is enough to get you started. If you are looking for more information on earnings quality you’ll find more information in my book, The Small Cap Investor: Secrets to Winning Big with Small-Cap Stocks.  You can claim your free autographed copy of my book when you try my Small Cap Investor PRO service today – just click here to get started.

In a nutshell, what you really want to understand is how dependable, and sustainable, are the earnings numbers that the company is reporting. The analysis I did on Lancaster Colony showed that management has taken a very conservative approach to reporting earnings. The market often likes conservatism. In fact, since Lancaster’s earnings announcement last Thursday the stock is up 5.6%. That’s a nice gain over a period when many other stocks have faltered.

If you would like to learn more about the companies I recommend, I encourage you to begin a trial subscription to Small Cap Investor PRO. You can likely cover the cost of a yearly subscription within just a few weeks of investing in my favorite stocks. Plus there is absolutely no risk when you sign up for a trial subscription. Just click here to find out more about how you can get started with Small Cap Investor PRO today.