Inside Earnings: Quality Is Key

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Inside Earnings: Quality Is Key
by Brian L. Burda, CFA, Vice President, Senior Equity Researcher, Schwab Equity Ratings®, Schwab Center for Financial Research
September 12, 2006

After a rash of Enron-style accounting scandals, investors have become understandably obsessed with the quality of corporate earnings. After all, fortunes were lost. And when the economy slows, some companies may be tempted to stretch a little—or a lot—to meet their earnings targets.

But what is earnings quality? Some would say that it's like truth or goodness—impossible to define, but they know it when they see it. We believe Schwab Equity Ratings takes a more disciplined approach. For the purpose of stock selection, we define quality as the odds that a company's reported earnings will (1) not be restated downward, (2) persist going forward and (3) increase in the future.

Who should be concerned about earnings quality? Well, value investors typically rely on measures that emphasize cheapness regarding a company's historical and prospective earnings. Growth investors generally prefer measures that emphasize the magnitude of a company's past and future earnings changes. As a result, all investors, regardless of style, have an interest in seeking stocks with higher earnings quality.

Cash is king
So, what specifically should quality-conscious investors be looking for, and where? A company's earnings are made up of income on a "cash" basis (ignoring sales for which money is due and expenses for which money is owed) plus so-called accruals. Corporations use these accruals to shift the recognition of cash flows over time in order to make earnings a better measure of company performance. The problem for investors is that accruals are based on accounting assumptions, judgments and estimates, which can contain errors that require correction in the future. Not only are accruals less reliable than cash, they can be more easily manipulated—think Rite Aid, Sunbeam and Computer Associates.

Our analysis finds that companies with a high percentage of earnings on a cash basis, as opposed to an accrual basis, tend to have higher earnings quality. So do companies that demonstrate an ability to "do more with less," that is, to make more efficient use of working capital such as inventories and receivables, and to generate more earnings with fewer assets. Schwab Equity Ratings call these factors "Earnings Alignment with Operating Cash" and "Efficient Management of Working Capital."

There are many stocks which Wall Street analysts consider "buys," but which Schwab Equity Ratings rates C ("hold") or lower. Why the difference? One possible reason might be that Schwab Equity Ratings look beyond the size and pace of a company's earnings growth to identify quality earnings: Net income may be rising as a result of accruals, rather than cash earnings, and inventory and receivables turnover is slower than that of other firms.

An assessment of earnings quality is critical in stock selection, but it is even more effective when used in combination with other types of information that have historically been shown to add value. Among them: improving earnings and price momentum, lower volatility and relative cheapness. Schwab Equity Ratings were founded on this "whole is greater than the simple sum of the parts" approach.

Looking for ideas?
To find your own set of candidate stocks from different sectors with a Schwab Equity Rating of A or B and quality earnings, use the "Stock Screener" on schwab.com>>Quotes & Research>>Stocks. In the "Stock Screener" section of the left column, click on "Screen Using Schwab Equity Ratings". Select "B or higher" from the Schwab Equity Rating drop-down list, and choose a Market Cap category and Sector as desired. At the bottom of the screener settings, click on "See Results." When you click each ticker, then click on the "Schwab's Viewpoint" tab, you'll see the rationale for the company's Rating. Look for stocks with quality earnings—they'll have "positive" ratings for "Efficient Management of Working Capital" and "Earnings Alignment with Operating Cash."

Charles Schwab & Co.("Schwab") rates stocks "A" to "F." Schwab's outlook is that "A" rated stocks, on average, will strongly outperform and "F" rated stocks, on average, will strongly underperform the equities market over the next 12 months. Schwab Equity Ratings are based upon a disciplined, systematic approach that evaluates each stock on the basis of a wide variety of investment criteria from four broad categories: Fundamentals, Valuation, Momentum and Risk.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Investors and clients should consider Schwab Equity Ratings as only a single factor in making their investment decision while taking into account the current market environment. Accordingly, Charles Schwab & Co., Inc. does not assess the suitability (or the potential value) of any particular investment. Schwab Equity Ratings are generally updated weekly, so you should review and consider any recent market or company news before taking any action. Stocks may go down as well as up and investors (including clients) may lose money, including their original investment. Past history is no indication of future performance and returns are not guaranteed.

The Schwab Center for Investment Research is a division of Charles Schwab & Co., Inc.

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