High earnings vs. high-quality earnings (2)

 Perhaps the most important factor that influences a company’s earnings is the quality of management. Some critical aspects of a company’s management which every investor must consider carefully are their commitment and competence, professionalism, future orientation, image building, investor friendliness and government relation building. The future earnings of a company are very much connected with the quality and competence of its management to a very great extent.

Lastly, a company’s modernisation and expansion plans also influence earnings. Some companies choose to put back some or all of its earnings into the business for future expansion. This is termed ‘plowing back.’

How to determine good quality earnings

When analysing periodic financial reports, investors should ask themselves three simple questions concerning a company’s earnings: Are the company’s earnings repeatable? Are they within the control of the company? And finally, are the earnings bankable, that is, can they be translated into cash?

We examine the above three questions in the following paragraphs:

Are the company’s earnings repeatable?

Some company’s record increased earnings by means of sale of assets, downsizing of employees and so on in order to reduce expenses. It follows that the quality of earnings realised through this approach is questionable because sale of assets is never repeatable. Once sold, assets cannot be sold again to produce more earnings and so the company would never be able re-produce such future earnings. The same applies for downsizing of employees and other such items.

Increase in sales and revenues as well as reduction in costs are the best routes to high-quality earnings. Both are repeatable. Sales growth in one quarter is likely to be followed by sales growth in the next quarter. Similarly, costs, once cut, typically remain that way. Investors are more apt to consider repeatable and fairly predictable earnings that come from sales and cost reductions.

Does the company control its earnings?

As mentioned in the preceding paragraphs, a company’s earnings could either be within or outside its control. A company whose earnings are consistently outside its control is not likely to be considered by investors since earnings follow a haphazard pattern. Cash sales – which the company does control – are the source of the highest-quality earnings; therefore investors should seek firms with earnings that closely resemble cash that is left after expenses are subtracted from revenues.

How is the company’s cash flow position?

There is a popular saying that “Do not count your chickens before they are hatched.” Most companies, however, enter sales as revenues, even though no money has exchanged hands. Cash payments often arrive later than receivables, so a company must wait before they can deposit revenues in the bank. The fact that customers can cancel or refuse to pay creates large uncertainties, which lower earnings quality. At the same time, generally accepted accounting principles give room for choices about what counts as reliable revenues and earnings.

Earnings per share (EPS)

Earnings per share refer to the portion of a company’s net income allocated to each outstanding share of common stock. EPS serves as an indicator of a company’s profitability.

It is usually calculated as:

EPS = Net Income

Total Shares Outstanding

For example, assume that a company has a net income of N30 million. If the company has total outstanding shares of 15 million ordinary shares for the entire period under consideration, the EPS would be N2, that is, N30 million divided by 15 million shares.

An important aspect of EPS that is often ignored is the capital that is required to generate the earnings (net income) in the calculation. Two companies could generate the same EPS, but one could do so with less equity (investment) – that company would be more efficient at using its capital to generate income and, all other things being equal, would be a ‘better company.’ Investors also need to be aware of earnings manipulation that will affect the quality of the EPS. It is important not to rely on any one financial measure, but to use it in conjunction with financial statement analysis and other measures.

Calculating other Earnings Ratios

Earnings Yield = EPS

Market Price per Share

Dividend Yield = Dividend per Share

Market Price per Share

Dividend Payout Ratio = Dividend per Share

Earnings per Share

Price Earnings Ratio (P/E Ratio) = Market Price per Share

EPS

Verdict

Evidently, high earnings are not as important as high-quality earnings. It is important that the quality of earnings must be those which are repeatable, controllable and bankable. Earnings that experience a surge because of a one-time, uncontrollable event are not earnings that are peculiar to the activities of the business and are therefore not sustainable. These earnings are as a result of luck, which is never a reason to invest.

Finally, those businesses that generate revenue but not cash are not engaging in profitable activities. When you invest, make sure your company is taking its earnings to the bank!

 

‘MUYIWA OLANREWAJU