Earnings Too Good To Be True?
Financial news, blogs, tweets, feeds and our own experiences all inform us that earnings are not all equal. Anthony and Breitner, in their small overview of accounting fundamentals highlight the limitations of financial statement analysis, “financial statements cannot provide a complete picture of the status or performance of an entity…financial statements are limited to monetary measurements (as opposed to other measurements), historical data only, and contain figures involving estimates” (2010, pp. 135-136). Having said this, the investment community pays a lot of attention to various ratios such as earnings per share (net income/number of common shares outstanding). But this number can be deceptive. Any one-time event to the good that might be reported as “other income” may skew this number. What is more, the larger the entity, the more difficult it may be to determine what caused an increase in EPS. In an often-quoted opinion, Warren Buffet prefers Return on Equity as a measurement:
The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share. In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if management and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure (Buffet, 1979 [From the 1979 Berkshire Hathaway annual report] as quoted in Vick, 2001).
There is a Better Way: The Inclusion of Qualitative Measurement
Anthony and Breitner suggest that due to the inherent limitations of financial statements, we should be concerned with the “quality of earnings” (pp. 150-154). Good sense and reason demand that we dig deeper into the why of certain ratios when examining financial statements for investments and strategic decisions.
But when considering the quality of earnings, Anthony and Breitner tell us that we must be judicious in this respect as well, “analysts and investors use indicators other than performance ratios…to evaluate the quality of a company’s reported earnings. Not all analysts define quality of earnings in the same way…therefore [this] analysis is a very subjective process” (p. 151).
There are always exceptions, but generally speaking, if something seems too good to be true, it is. Organizations are no different. When it comes to earnings, consistency, debt ratios, and future probability of earnings, there is no substitute for a thorough understanding of the line of business itself. This understanding works in conjunction with the numbers and helps paint the whole, and more accurate picture. What are some tangible ways that you might implement a meaningful qualitative measurement to underpin operational performance?
Anthony, R. & Breitner, L. (2010). Core Concepts of Accounting (10th Edition). Upper Saddle River, NJ: Pearson Prentice Hall Publisher.
Vick, T. (April, 2001). Picking Stocks the Buffet Way: Understanding Return on Equity. AAII Journal. Retrieved July 28, 2010 from http://www.scribd.com/doc/6775318/Picking-Stocks-the-Warren-Buffett-WayUnderstanding-ROE
Edited Image Source: Smithsonian Institute: http://goo.gl/QlkHV