Sunday, October 23, 2011

Quality of Earnings: Chapter 6

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.

This chapter is about how one-time charges or benefits can mask true earnings growth (or declines). The author takes the reader through a number of public company examples where temporary impacts to earnings masked changes in earnings power.

For example, O'Glove shows the reader how IBM's 19% annual earnings growth is deceptive. After taking into account pension plan assumption changes, temporary tax rates, incentive compensation freezes and changes in depreciation, earnings are actually far less impressive.

A common theme throughout this chapter is related to advertising expenses. New managers will often increase or decrease advertising expenses, which can dramatically alter current earnings without much affecting current revenue. Future revenue, however, is often affected. Shareholders who take the time and effort to dig into such changes can profit from a market that misunderstands the earnings impact of increases or decreases to advertising expenses.

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