Education: Aggressive Growth Investing

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How to Gauge Earnings Quality

Earnings and earnings growth are the fuel that drives stock prices. Zacks readers know specifically that earnings estimate revisions are the best predictors of future stock price movements. However, what if those “earnings” aren’t all that they seem? Companies can come up with creative ways to exhibit strong earnings growth, which can mislead investors. It is important to know the “quality” of the company’s earnings as well as the growth rates and estimate revisions. So what is earnings

Quality Control

Earnings are high quality first and foremost when they can be repeated. Countless companies play games by including one-time gains into their earnings per share calculations. Most firms have investments of their own in other companies, and like us, they sell those shares. Gains from sales of investments are a popular way to inflate earnings and reduce their quality. There are only so many times that a company can use the profits from their investment sales to pad earnings. We want operating earnings from the company’s core businesses.

High quality earnings are important because they are awarded with higher price/earnings ratios, which directly translate into higher stock prices. This makes intuitive sense because by definition, these earnings are repeatable, so investors can bank on them recurring more frequently, and thus feel comfortable paying more for them.

INTC and MOT Played That Game

Intel and Motorola are two companies whose earnings per share numbers have repeatedly benefited from the sale of investments. These two giants have numerous investments purchased with their enormous cash hoards, and they would include the profits from these sales in their EPS numbers. A few years ago in 2001, Motorola reported third-quarter earnings that soundly beat estimates, but the stock fell over 10% because investors realized that the earnings were low quality and not repeatable. This was during a vicious bear market, so it was understandable that the company wanted to make their earnings look good.

What to Look For?

Strong sales growth and cost cutting are key to recurring earnings. However, cost cutting can only last so long, so that leaves sales growth as the engine of high quality earnings growth over time. Beware if a company’s sales growth starts to slow, but its earnings keep registering healthy gains. This has been the case with IBM over the past few years. Revenue growth has slowed to the low-to-mid single digits while earnings per share have often grown by double digits. Wall Street grew wise to this and didn’t reward IBM with big stock price gains if sales growth was absent.

Cost cutting is necessary and good, but the big gains will come from aggressive growth stocks that show explosive and consistent revenue growth. Otherwise, where will the incremental earnings come from? Business executives should be spending their time figuring out how to grow revenues rather than ways to pad EPS numbers by using tricks. There is only so much fat to cut before you hit bone, so look to the top line to improve your bottom line.