Checklist Series, Part 11: Quality of earnings
People mean a lot of different things when they talk about “quality of earnings.”
There’s the business finance angle. How consistent are the various sources of revenue? How reliably are they turned into bottom line earnings?
And then there’s the accounting angle. When we say “net income,” what exactly are we talking about? How much is actual cash profits, and how much is accounting shenanigans?
Ultimately, quality of earnings is about trust — in management, in accounting, and in the business model itself.
I’m going to focus on accounting risks in the next “checklist series” entry (spoiler!), so today we will examine it from the other angle.
What are the hallmarks of “high quality” earnings in this context?
How consistently can we rely on them?
All things considered, the more stable earnings and cash flow are over time, and through business cycles, the more highly we are willing to value them.
What is the relationship between earnings and cash flow?
In the words of the immortal Wu-Tang Clan, “Cash Rules Everything Around Me.”
The income statement is a notoriously malleable financial statement, subject to all sorts of manipulation by the various assumptions that can be made around the timing of revenue and expense recognition. Ultimately, you can only bullshit for so long before cash flows fail to hit the bank account. And so we want to look at the difference between earnings and operating cash flow, and understand why these numbers might not agree. Over short time periods, it’s very likely that you could see significant discrepancies between the two profitability measures. Over the longer term, if they don't converge, it can (and should) raise red flags.
Look at the Return on Invested Capital
What happens to profits retained and not paid out to shareholders? They are reinvested in the business, and either add to future investment returns, or detract from them. A mature company may run out of reinvestment opportunities, or see ROIC deteriorate over time. Meanwhile, a company with promising growth avenues can see ROIC boom - which can be a harbinger of consistent future growth.
High-quality earnings don’t just recur — they compound. A company earning 20% on reinvested profits doesn’t need to chase the next big idea. Its next big idea is doing more of what already works.
The Recurring Revenue Tailwind
Intuitively, we know that a revenue source is more valuable when we can rely on it to repeat over time. An annual subscription is far more reliable than a one-time sale that must be repeated year after year.
Customer retention is a huge bonus. So is a revenue stream that doesn’t require a new sale every year. Even better if the service provided is a critical one, resistant to economic slowdowns or recession risk. Your home and auto insurance is a lot more sticky than your subscription to the Playstation Network.
Leverage - financial and operational.
Archimedes said “Give me a lever, a place to stand, and I shall move the world.” This is the impact of leverage! It can magnify both gains and losses. When we look at the quality of a company’s earnings, we don’t want to rely too heavily on financial leverage (that is, debt). That’s risky, and a move against you can compound your losses.
What about operational leverage (that is, high fixed costs)? Also risky, but if you understand the nature of the business, high operational leverage can supercharge bottom line growth if revenue ticks up, even slightly. It can do the opposite if sales slow, even just a little. Understanding a company’s cost structure is a key element to evaluating the inherent risk, and the repeatability of current earnings.
Capital expenditures as a drain on shareholders.
Finally, we want to understand the extent to which a company must invest in capital equipment to maintain current earnings and cash flow. Most management teams love to classify any Capex as “growth Capex” versus “maintenance Capex” in order to inflate “free cash flow” figures. This will tend to be their bias. Knowing this is important, because we can’t just assume that there’s a clear delineation between growth and maintenance Capex. It requires sharp analysis and industry knowledge to evaluate the reasonableness of management’s numbers.
The more money required to invest to maintain current earnings, the less is available to distribute to shareholders via dividends or share buybacks. This is why I tend to prefer “capital light” businesses that can maintain earnings without huge capital investments.
The takeaway
Earnings tell a story, but it’s not always an honest or accurate one. In assessing a company’s earnings quality, we look for the clues that confirm or deny our suspicions or beliefs. Just as we look for high quality businesses, we look for a bottom line we can have faith in; because at the end of the day, that’s what we are buying.