Saturday, October 22, 2011

Quality of Earnings: Chapter 5

Investors rely heavily on the financials that companies release. But managements have significant leeway when it comes to creating its results. In this book, Thornton O'Glove tells investors how to judge the quality of a company's earnings, in order to both protect against fraud and find value.

What fools a lot of investors and analysts who try to determine a company's earnings power are non-recurring gains and losses. Certain non-operating and/or non-recurring events which added to (or subtracted from) profits are likely to make income statements look better (or worse) than they otherwise would. To determine a company's earnings power accurately, an investor must identify and remove the effect of these items on the income statement.

In many cases, it is easy to identify which events are non-operating and/or non-recurring. But it can get difficult. An event that could be considered recurring for one company may not be for another. For example, a land sale gain may be recurring for a real-estate company, but non-recurring for a wholesaler that is moving its headquarters after several decades. An understanding of the business under consideration is important before it can be determined if an event is recurring or not.

Through no fault of the company's managers or accountants, serious misinterpretation of a company's income statement can occur if non-recurring items are not excluded from earnings power calculations. O'Glove discusses the situations of several companies where stock prices suggested investors believed that earnings growth was sustainable, when an analysis of non-recurring events suggested earnings would fall in future years.

In other cases, managers and accountants of companies can use non-recurring income to actually game earnings numbers. O'Glove describes a few examples where it appears managers took advantage of certain one-time occurrences to boost short-term income, at the expense of shareholders. Readers are advised to investigate for any abnormal sources of income to avoid falling prey to such tricks.

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