Definition of quality of earnings: The extent to which the profits reported by a company are likely to recur as they are driven by the core operating activities of the business.
What is quality of earnings?
Quality of earnings is a lense through which we can analyse how news about a companies latest profit will be interpreted by investors.
Earnings with high quality, are those which are almost entire driven by the underlying profit from the business’s core activity, such as buying and selling widgets.
Earnings with low quality will include items that are one-off in nature and are either attributed to luck or an uncontrollable event. Examples include:
- A gain on the disposal of a strategic asset such as a subsidiary
- A gain or loss arising from a significant and favourable change in foreign exchange rates during the year
- A gain from complex accounting which doesn’t relate to the underlying trade of the business, for example the reversal of a goodwill impairment.
Furthermore, we can apply quality of earnings analysis to determine whether an increase in the reported profits of a business in their financial statements should lead to a large or small increase in the value of that company.
An introduction to quality of earnings
The principle which underpins quality of earnings, is that the core operations of a business is like a well oiled machine.
Sales tactics tend to continue to work, costs continue to remain controlled, and therefore a business which turns out a profit in one year, is quite likely to turn out a profit (or even a higher one) in the next. Gross margin is usually a very stable ratio.
This means that investors don’t just see a business as the value of its next years profit – they see a business as a whole series of profits, stretching out into the distant time horizon.
By buying shares, investors are owning the right to receive dividends based on these future years, and hopefully – growth.
Therefore, if a company generates a profit of £1m from its core operations, then the business may be valued on the basis of £1m profits per annum into the foreseeable future.
That being said, businesses don’t just stick to their core operations.
- Sometimes they experiment with new product lines
- Sometimes a one-off opportunity occurs to generate more revenue temporarily
- Sometimes the accounting rules (such as IFRS) can result in a large profit being recognised which isn’t reflective of underlying trade.
Quality earnings analysis
These one-off blips in profit are a distraction for equity investors.
They may be prepared to pay for 10 times the core annual profits of the business, on the assumption that the business will continue to churn that profit out for decades to come.
However a one-off windfall, like success in a legal case or a temporary surge in sales due following news coverage, won’t receive the same treatment.
Investors will not be prepared to pay 10 x this uplift in profits, because they don’t believe it will recur in the future.
Therefore a quality of earnings analysis, often presented as a table or waterfall chart, will begin with the profit reported in accordance with generally accepted accounting principles. It will then add or deduct one-off items which are either unconnected with the core business or is not expected to re-occur.
This will reach an adjusted profit figure, which will be the basis on which a shareholder might value the company.
How is the phrase quality of earnings used in a sentence?
“Quality of earnings has suffered this year as the gain on the sale of the old factory has inflated the profit reported in the income statement.”
What else you should know about quality of earnings
Quality of earnings analysis tables are performed both internally and externally of a company.
Internally, management are interested in quality of earnings because they don’t want to be lulled into a false sense of security by misreading an uptick in profits. If an uptick is only the result of a temporary items, then they would rather have visibility over the underlying picture.
Externally, analysts will perform a quality of earnings analysis before reaching a conclusion as to whether a new reported financial result is actually an outperformance relative to the market’s expectations. If adjusted earnings are lower than expected, then higher GAAP profits may be almost disregarded by shareholders and won’t encourage them to buy more shares.
How does the definition of quality of earnings relate to investing?
Quality of earnings is a useful concept which helps to cut through the noise and volatility in a companies reported profit over the years, to look at how its core business is actually performing.
It’s often the core business which produces the majority of long term income and profits, yet small short term items can easily mask the underlying trend.