Fundamental Tips for Seeing Through the “Earnings Massage”
We recently posted about understanding the limits of the famous P/E ratio: while a perfectly useful “rule of thumb” metric, P/E ratio ignores not only vital complexities that affect the fair valuation of any equity, but companies’ ability to massage their reported earnings numbers to avoid undesirable outcomes (or, at least, postpone them as long as possible). Today, we’re going to examine this issue in a bit more detail: what should you look for when considering how literally to take a firm’s reported earnings?
- Moving revenue around: firms have to make strategic decisions about how to account for various sources of revenue. Imagine, for instance, that a construction firm receives a 4-year contract for building services with a city government. The contract provides for $1 million a year over the term of the contract, but the city decides to pay with an upfront lump sum. Logically, this contract would be accounted in an amortized fashion, distributed over the length of the deal. An unscrupulous firm, however, could count the payment as $4 million in revenue for the current quarter. If the contract goes well, investors may never be the wiser. But what if the company is sued for poor performance after year 1 of the deal? They may very well be left with millions in recorded earnings that aren’t in fact earnings at all. Be particularly wary of large jumps in revenue for otherwise struggling firms — especially if the firm doesn’t provide a sound explanation for the sudden shift.
- Inventory Games: Properly accounted inventory won’t be recorded as revenue until an ultimate sale is made. But remember, most businesses don’t actually sell at the retail level. Take, for instance, a car manufacturer having a rough quarter. They could attempt to ship out a large number of vehicles to dealers just before the quarter ends, treating them as sales when they’re properly regarded as inventory. Returns, poor sales, manufacturing defects—any of these factors could cause these supposedly solid earnings to vanish. Be particularly wary of sudden shifts driven by large inventory adjustments. Unduly pumping up inventories in the current quarter is a sure recipe for disappointing results in the future, as the excess supply works its way through the sales process.
- Questionable Expense Accounting: expenses can be questionably tallied in a similar fashion. You can read about a particularly interesting case in this regard here. Remember those AOL free trial CD’s that floated around everywhere in the 1990’s? AOL produced so many that their production costs would have shifted their firm into the red! They attempted to obscure this fact, however, by counting the cost of making the CD’s as “marketing capital,” that could then be expensed over the multi-year length of the marketing campaign. The SEC caught and punished AOL in this case, but savvy investors can never assume that regulators are out ahead when evaluating a stock.
- Manipulation to the downside: firms don’t always manipulate their price to the upside. For instance, a firm having a great quarter that they don’t expect to repeat could introduce a major “one-time operating expense” that they then adjust downward in future quarters to provide a buffer for carefully managing their stock price. Always remember: firms are often employing these tactics to manage their stock price rather than push it up unsustainably.
Why would a company manage its earnings anywhere but up? Remember, more traders than ever before are attempting to profit by buying on earnings “Beats” and selling on “Misses.” And many of these investors aren’t paying enough attention to the magnitude of these events. By managing their financials to always Beat, but never by too much, companies can help drive a stable valuation for their firm.
There’s no substitute for comprehensive price data that allows investors to get a strong read on the historical tendencies of a given firm’s earnings report reations—it’s a decisive advantage for traders armed with platforms like News Quantified. If you’d like to learn more about using news, data, and your understanding of equities to find consistent, market-beating profits, we recommend one of our totally free virtual training seminars. You can claim a spot in our next session using the button below.