Checking the Quality of Company Earnings
The following sidebar Quantifying Earnings Quality by Cecily J. Fluke with the article, Priced for Perfection by Nathan Vardi in the June 10, 2002, issue of Forbes gives ways to check the quality of company earnings.
We looked at six pairs of numbers, comparing growth in one with growth in the other. In each case earnings quality was associated with a higher growth in the first quantity than in the second. The pairs: cash flow from operations (net of tax savings from stock options) and diluted earnings per share; depreciation/amortization and capital expenditures; cost of sales and ending inventory; sales and receivables; operating income and long-term debt; sales per share and diluted earnings per share.
After coming across this article and reading the above sidebar, I began wondering if the six pairs of numbers were useable. Could I find the specific pieces of data, do the calculation, and use the information in a meaningful way? Below are the results of my efforts. I chose American Eagle Outfitters (AEOS), a stock I had just completed analyzing using my worksheet. I have listed my findings and opinions below if you want to replicate them or want to try it with one of your stocks.
Each of these six items require calculating growth rates using 2001 and 2000 data. The growth rate calculation is: (2005 figure minus 2004 figure) (÷ by 2004 figure) (x 100) = percent growth. I used data from Reuters.com (may require free registration).
In each case, for quality earnings, the first growth rate of the pair should be greater than the second growth rate.
1. Cash Flow from Operations growth rate versus EPS growth rate----85.7% vs 159.4% respectively. (Unusually high EPS growth rate)
a) Cash Flow from Operations----use Total Operating Activity on the Annual Cash Flow Statement
b) EPS----use Diluted Excluding Extraordinary Items on the Annual Income Statement
2. Depreciation/Amortization growth rate versus Capital Expenditures growth rate---13.8 % versus 25.5% respectivelty. (Spent more for Capital improvements than was gained through depreciation deductions)
a) Depreciation/Amortization/Depletion----use Depreciation/Amortization/Depletion on the Annual Cash Flow Statement
b) Capital Expenditures----use Capital Expenditures on the Annual Cash Flow Statement
3. Cost of Sales growth rate versus Ending Inventory growth rate---13.3% versus 14.4% respectively. (OK---very close)
a) Cost of Sales---use Cost of Revenue on the Annual Income Statement
b) Ending Inventory---use Total Inventory on the Annual Balance Sheet
4. Sales growth rate versus Receivables growth rate---31.1% versus 9.5% respectively. (Good---goods have actually been paid for)
a) Sales--use Revenues on Annual Income Statement
b) Receivables--use Accounts Receivable (Trade), Net on the Annual Balance Sheet
5. Operating Income growth rate versus Long-Term Debt growth rate---172.1% versus -100% (Good---They paid off long-term debt)
a) Operating Income--use Operating Income on the Annual Income Statement
b) Long-Term Debt--use Total Long-Term Debt on the Annual Balance Sheet
6. Sales per Share growth rate versus Earnings per Share growth rate---26.3% versus 159.5% respectively. (Unsually high EPS growth rate)
a) Sales per Share--calculate it--Use Revenue on Annual Income Statement divided by Diluted Weighted Average Shares on the Annual Income Statement
b) Earnings per Share--use Diluted Excluding Extraordinary items on the Annual Income Statement
An interesting exercise. I am not sure which of these I will use in addition to my usual calculations---probably numbers 1 and 4.
1:56:33 PM 
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