High earnings vs. high-quality earnings (1)

  There is no doubting the assertion that stocks with higher earnings are more likely to outperform the market than others. But how do you determine whether a company’s earnings have some quality that might trigger investors’ demand for the stock? While actual naira value per share informs investors how much they would be earning per share on their investment, it is not sufficient to conclude that this represents a measure of quality of earnings.

Investors have been observed to focus on actual kobo per share delivered, resulting either in share prices going up when companies beat earnings estimates, or falling when earnings come in below projection. At first glance at least, when it comes to earnings, size matters most to investors. Savvy investors, however, take time to look at the quality of those earnings. The quality rather than quantity of corporate earnings is a much better gauge of future earnings performance. Firms with high-quality earnings typically generate above-average Price Earnings (P/E) multiples. They also tend to outperform the market for a longer time. More reliable than other earnings, high-quality earnings give investors a good reason to pay more.

What are earnings?

Earnings refer to the amount of profit a company is able to generate during a specific period, usually, quarterly, half-yearly and annually. Earnings typically refer to income that a company realises after it must have taken out its taxes for the period. Ultimately, a business’ earnings are the main determinant of its share price, because earnings and the circumstances relating to them can indicate whether the business will be profitable and successful in the long run.

Earnings are perhaps the single most relevant figures in a company’s financial statements because they show how profitable a company really is. Usually, investors compare estimates of a company’s earnings, done through fundamental analysis, with actual periodic earnings as released by the company from time to time. It follows that decisions regarding buying, holding or selling the company’s stock are made from this comparison. In most situations, when earnings do not meet either of those estimates, a company’s stock price will tend to drop. On the other hand, when actual earnings beat estimates by a significant amount, the share price will likely surge.

What factors determine a company’s earnings?

There are several factors that affect a company’s earnings. Some of these factors are within the control of the company, while some others are outside the control of the company. Let us examine these two categories of factors in the following paragraphs.

Uncontrollable factors –

Monetary and government fiscal policies have major significance on a company’s cost of capital. Inflation appears to be a very good example in this case. Inflation can generate business uncertainty, negate a company’s accounting systems, and affect the relative prices that a company faces. As an example, consider a manufacturing company that keeps a stock of inventory, its selling prices are expected to rise with an increase in inflation rate, thereby giving its earnings a boost. Inflation thus acts as a catalyst in influencing the earnings of a company.

Another important factor that influences earnings is the price of inputs and raw materials. Falling jet fuel prices, for example, can improve airline industry profits. Changes in the weather can boost earnings growth. Think of the extra profits that electrical utilities enjoy when temperatures are unusually hot or cold.

In addition, political instability or a general economic recession may significantly reduce demand for a company’s products.

Consider the effects of exchange rate changes. For example, if a company must convert its foreign currency profits back into the naira, assuming the naira is falling against the foreign currency, the company’s earnings will experience boost. But, management has nothing to do with those extra earnings or with ensuring they occur again in the future. On the other hand, if the naira moves upwards, earnings growth could come in lower.

We have discussed some uncontrollable factors that affect a company’s earnings so far. Let us now shift our attention to controllable factors that have influence on a company’s earnings.

Controllable Factors –

The first of this category of factors will most likely be sales, revenue or turnover. It is common knowledge that a company that records a high turnover is more likely to return good quality earnings, except of course it fails to manage its expenses properly. Investors seek companies with earnings figures that closely resemble income that is left after expenses are subtracted from revenues.

A company’s market share is also very important in analysing earnings. The market share represents the proportion of sales that the company is able to achieve relative to its competitors within the same industry that it operates. It follows that a higher market share is more likely to translate into higher earnings.

Also, capacity utilisation is important in ensuring a company’s targeted earnings are met. Where the company can efficiently make use of its available resources, its earnings is more likely to record significant boost.

 

‘MUYIWA OLANREWAJU