Sunday, April 14, 2013

Quality of Earnings Matters

Earnings are important, but it's the quality of the earnings that counts.

When it comes to fundamental analysis, the most important item is earnings. Indeed earnings are the lifeblood of a company. Without earnings, a company cannot survive. When a company reports earnings that are above expectation, the price of the stock rises. And when it reports earnings that are below expectation, the stock price drops.

When we look at earnings, we should look at earnings per share (EPS) and not only at the amount. A company earning RM10 million with an issued capital of RM10 million comprising of 10 million shares issued at RM1 each is better than a company earning RM100 million but with a capital of RM500 million comprising 500 million shares of RM1 each. While the former's EPS is RM1, the latter's EPS is only 20 sen. Many people look only at the amount earned when they should be looking at the EPS.

Another feature often overlooked is the quality of the earnings. Earnings from sales and received in cash is the highest quality of earnings. Earnings placed under Accounts Receivable may not be fully realized, and therefore has a lower quality. Earnings from sale of assets, not repeatable, are the lowest form of earnings. So when you look at earnings, you must take into consideration the quality of the earnings.

Ideally, earnings should go up in tandem with sales of the company's products or services, year after year. Sometimes earnings improvement is the result of cost cutting. If the cost cutting comes from decreasing the labor force thus demanding more work from each worker, this is not so good even though competency is enhanced.

The best scenario is that the quality of its products is upgraded resulting in more sales and better margins.

Next time you look at EPS, don't forget to look at the quality of the earnings.

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