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Stock Strategist

Earnings at These Two Firms Are Not Created Equal

With earnings just around the corner, we offer a few words on earnings quality.

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Given Wall Street's fixation on near-term earnings-per-share numbers, the market sometimes overlooks earnings quality--the underlying strength of a firm's reported profits. Before your eyelids drift shut, consider this: There's money to be made (and preserved) in the dry task of earnings-quality appraisal. An established body of research (Sloan (1996, 2002), Swanson and Vickrey (1997), Chan, Jegadeesh, and Lakonishok (2001), Collins and Hribar (2000), Penman and Zhang (2002)) shows that firms with high-quality earnings (i.e., strong cash earnings) tend to produce higher investment returns, while low-quality earnings are linked to underperformance.

Whether you wish to screen for earnings quality in prospective stock purchases or to track the earnings strength of firms you own already, we think the framework described below will be a handy addition to your investment tool belt. To illustrate, we serve up a couple of actionable ideas--the first, a 1-star, no-moat company with shaky profits; the second, a 5-star, wide-moat firm whose earnings are rock-solid.

Show Me the Cash
At the heart of earnings quality are accruals--accounting entries that are used to recognize income in a different period than the associated cash flow. Because cash flows can be lumpy, they may not represent a firm's true profitability for any given period of time. Management must therefore use its discretion--via accruals--in "smoothing" the earnings it reports. This flexibility is both necessary and helpful. A credit sale, for example, is still valuable even though the company hasn't yet collected the cash.

The trouble starts when cash flows and earnings diverge unsustainably. It's a red flag when earnings are consistently composed of more accruals, which are subjective, than of actual cash, which is not. At best, this may indicate cyclical business conditions. Unfortunately, it may also point to deteriorating business fundamentals. At worst, it can signal accounting chicanery. The most notorious shenanigan is to boost current-period earnings by inflating revenue or deflating expenses--the financial equivalent of setting the fuel gauge to "full" when the tank is empty.

Our goal here, though, is to stay ahead of the firm's fundamentals, rather than detect accounting fraud. How can an investor check for potential earnings weakness? A quick trick is to look at the ratio of cash flow to net income. To isolate the component of net income that consists of accruals, take the difference between net income and operating cash flow:

Total Accruals = Net Income - Operating Cash Flow

Then, divide by total assets in order to "scale" accruals and make them comparable across peer firms:

Relative Level of Accruals = (Net Income - Operating Cash Flow) / Total Assets

Over long periods of time, this ratio should approximate zero. Another shorthand experiment is to compare the rate of increase in net income to that of cash from operations (assuming both are increasing). If income is rising faster that cash flows, it means accruals are getting proportionately larger, which is suspicious.

We ran a screen to spot firms whose operating cash flow has trailed net income for several quarters. We've excluded sectors such as finance and housing, where accrual metrics aren't a good proxy for earnings quality. On the flip side, we looked for firms with high earnings quality, which often make good investment candidates. As you will see below, the differences were stark.

A Case of Accruals Growing Out of Hand
In 2006, farm products company  Bunge (BG) generated negative $289 million in cash from operations, yet reported an accounting profit of $521 million. Magic?

Accruals amounted to 1.5 times Bunge's net income, or a whopping 6% of total assets. A quick glance at the cash-flow statement shows that legitimate working capital adjustments explain part of the story, but not all. In 2006 Bunge recorded about $700 million in noncash income--mostly in foreign exchange gains, deferred income taxes, and asset sales, as well as transactions lumped into a mysterious category named "other". The company also recorded lower depreciation expense as a percentage of assets in 2006, with the effect of boosting net income. Had Bunge applied the same depreciation rate relative to assets as it did the year earlier, pretax earnings would have been $25 million lower.

While this simple check is insufficient to allege management aggression, it should prompt us to examine the strength of Bunge's business. With so much of earnings relating to one-time, non-operating items, what is the firm's real profit-generating capacity? What will happen to Bunge's earnings if the currently favorable foreign exchange and commodity price winds turn against it? When we combine these observations with other ominous signs at Bunge, including declining gross margins and inventory turns, our skepticism grows.

A Firm That Generates Pure Cash
At the opposite end of the earnings-quality spectrum is uniform rental company--and steady money machine-- Cintas (CTAS). For every dollar of reported earnings, Cintas generates an average of $1.43 in cold, hard cash from operations.

It is comforting to know that, in addition to Cintas' strong competitive advantages, robust balance sheet, and other investment virtues, its earnings are backed up by the real deal.

With the caveat that this exercise is merely a starting point, and that cross-sector comparisons should be approached with caution, we can still conclude that Cintas' earnings health far outmatches Bunge's.

The Bottom Line
Like a sports car running on fumes, a company's reported earnings may look great, and then--at some point in the near future--simply stall. If you haven't kept an eye on the fuel gauge, you may wind up stranded.

While weak earnings quality alone doesn't necessarily indicate a poor investment, we are generally less confident in firms with a high level of accruals. If it turns out that prior accounting improperly "padded" earnings, large write-offs or restatements may follow. For companies that show a consistent lag between cash flow and reported income, it doesn't hurt to dig a bit deeper before dishing out your hard-earned investment dollars.

Ryan McLean does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.