Quality of Earnings by Thornton L. O’glove

The book starts by making a case for not trusting analysts. One of the main reasons offered is their incentives are aligned towards the corporations, brokers and the banks — not the individual investors. The book is not very kind to auditors and the accountants either. They get paid by the company and may be inclined to get away with as much as possible “legally”.

He moves on to the shareholder letters. Although written by the media relations, it still gives a color to the bland legal language of the rest of the reports. It is possible to find inconsistencies here, compared to the rest of the report. In such cases, one should tread carefully.

Differential disclosure refers to finding contradictory information or different information in different documents. Legally the management is required to provide all the relevant information. They do so by hiding across documents and in the footnotes. Investors must be wary of such situations and behave accordingly.

Then there is the case of non-operating/non-recurring income. Many a times, a high EPS is a result of non-recurring incomes like tax benefits, sale of assets, favorable exchange rates etc. Unless careful attention is paid, one may classify non-recurring income as income and face the consequences by paying higher for the company than what is safe. Investors should also pay particular attention to increasing expenses, tax reporting, inventories, accounts receivable. and accounting changes. Each of these are dealt in a different chapter.

Of particular interest to me was the inventory and account receivable chapter. Inventory management may have significant short term effects on the stock. For example, if the revenues rise, the company builds up inventory in anticipation of rising sales. But if overdone, the inventory will have to be written down — decreasing earnings in later quarters. The is especially relevant in case of companies who are involved in fashion, computers, or products which become out of fashion pretty fast. Particular attention must also be paid to accounts receivable. Increasing accounts receivable means that the company is extending payments to the dealers — not a good sign for the business.

Similarly, attention must also be paid to accounting changes. Is the depreciation used is straight line (less conservative) or accelerated (more conservative) ? Is the inventory practice LIFO or FIFO ? Pensions and incentives also make noticeable changes in the earnings of the company. Special attention must be paid if the company changes its policies. This generally does not bode well for the shareholders.

All in all, a very informative and enjoying read.

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