Quality of earnings definition
/What is the Quality of Earnings?
Quality of earnings refers to the proportion of income attributable to the core operating activities of a business. Thus, if a business reports an increase in profits due to improved sales or cost reductions, the quality of earnings is considered to be high. Conversely, an organization can have low-quality earnings if changes in its earnings relate to other issues, such as the aggressive use of accounting rules, the elimination of LIFO inventory layers, inflation, the sale of assets for a gain, or increases in business risk. In general, any use of accounting trickery to temporarily bolster earnings reduces the quality of earnings.
Impact of the Quality of Earnings on Stock Prices
The quality of earnings reported by a business can have a profound impact on its stock price. Here are some of the impacts:
Investor confidence. When earnings quality is high, investors are more confident that the earnings accurately represent the company's performance and future prospects. This can reduce perceived risk, making the stock more attractive and potentially driving up its price.
Predictability of earnings. Companies with high-quality earnings generally show stable and predictable earnings patterns, indicating a well-managed business. Stocks of such companies are likely to trade at higher multiples, as investors value consistency and reliability.
Valuation multiples. Investors often reward companies with high-quality earnings with higher valuation multiples (like price-to-earnings (P/E) or price-to-sales (P/S) ratios), as these companies are seen as less risky and more likely to sustain growth over time.
Market reactions to earnings reports. A high-quality earnings report, which shows sustainable growth and profitability, tends to lead to positive market reactions. Strong quality of earnings signal that growth is more likely to continue, prompting an increase in stock prices.
Impact on institutional investors. High-quality earnings make a stock more appealing to institutional investors (mutual funds, pension funds, etc.), who often focus on stable, predictable returns. Increased demand from institutional buyers can push up the stock price.
Risk of accounting adjustments. Low-quality earnings often stem from accounting techniques that may eventually require restatements or adjustments. Such events typically cause stock prices to drop sharply due to lost investor trust.
Long-term shareholder value. High-quality earnings generally indicate that a company’s growth is sustainable, aligning with long-term value creation, which appeals to long-term shareholders and enhances the stock’s value over time.
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The Interpretation of Financial Statements
Characteristics of High-Quality Earnings
A key characteristic of high-quality earnings is that the earnings are readily repeatable over a series of reporting periods, rather than being earnings that are only reported as the result of a one-time event. In addition, an organization should routinely provide detailed reports regarding the sources of its earnings, and any changes in the future trends of these sources. Another characteristic is that the reporting entity engages in conservative accounting practices, so that all relevant expenses are appropriately recognized in the correct period, and revenues are not artificially inflated.
The Impact of Inflation on the Quality of Earnings
A modest level of inflation has no impact on the quality of earnings, since it is relatively immaterial. When the inflation in a country stays low - two percent or less - it is typically ignored when considering the quality of earnings. However, this is not the case for more robust levels of inflation, where rapid increases in prices can lead to reported results that are far higher than the year before, simply because prices have been increased to keep pace with increases in costs. In this situation, a business can provide disclosures about what its revenues and profits would have been without the effects of inflation; doing so would contribute to a much higher quality of earnings.
Example of Earnings Manipulation
An easy way for a business to manipulate its reported earnings is to lower its capitalization limit, so that more expenditures are classified as fixed assets. This means that expenses are deferred to later periods, when they are recognized through depreciation. This results in a bloated fixed asset register, but can deliver an increase in profits over the short term.