A Deep Dive Into Earnings Quality
Prof. Doron Nissim provides a detailed analysis of earnings quality, with a focus on earnings sustainability and its implications for valuation.
In this post, I would like to share the lessons I learned from Prof. Doron Nissim at Columbia University, who authored a paper titled “Earnings Quality, Fundamental Analysis, and Valuation,” published on March 1, 2021. I found it valuable to analyze financial information in today's environment, where companies often distort and adjust their financial reporting. While many companies make legitimate earnings adjustments, I've encountered some public companies that make questionable adjustments.
This raises a personal question for me: Do they genuinely understand what they are doing? Are these adjustments made voluntarily, or are they designed intentionally?
You can access the paper through the link below:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3794378#Professor Doron Nissim is currently the Ernst & Young Professor of Accounting and Finance at Columbia Business School. At CBS, he teaches several courses, including Earnings Quality and Fundamental Analysis (MBA and EMBA), Financial Statement Analysis and Valuation (Ph.D./M.S.), and Fundamentals-Based Investment Management (MBA). Although I haven't had the opportunity to enroll in one of his classes, his research provides a thoughtful analysis of why earnings quality is important and how to evaluate it.
So, without further delay, let’s dive in!
I. What is Earnings Quality, and Why Should Investors Care?
Earnings quality refers to the sustainability and reliability of a company's reported earnings. While many investors focus on a company's earnings per share (EPS) or price-to-earnings (P/E) ratio, these figures don't tell the whole story. A company with seemingly high earnings today might be engaging in practices that inflate those earnings, making them unsustainable in the future.
As an investor, it is crucial to go beyond the headline numbers and assess the underlying quality of those earnings to make sound investment decisions.
There are several definitions of earnings quality, but sustainability is the most important for investors. This means that the earnings a company reports today are expected to continue. Sustainable earnings come from core operations, excluding one-time items, reflect proper expense matching, and are measured consistently year after year. High-quality earnings provide a reliable basis for the following:
Valuation: Analysts use earnings to estimate a company's value through relative valuation (comparing multiples like P/E ratios) and fundamental valuation (like discounted cash flow models). If earnings are not sustainable, these valuation methods will be inaccurate.
Assessing Earnings Power: Sustainable earnings represent the true earnings power of a company – its ability to generate profits consistently.
And it matters more than ever.
Professor Nissim outlines three primary reasons why evaluating earnings quality is more crucial for investors now than in the past:
The Declining Trend in Long-Term Real Interest Rates: As real interest rates have declined over the past few decades, the present value of a company's long-term profits makes up a larger portion of its total intrinsic value. In other words, the duration of equities has lengthened, making long-term sustainability of earnings a critical factor in determining a company's value. Therefore, the quality and persistence of those earnings have become more important in assessing a company's true worth.
The Rise of Intangible Intensity: The increasing significance of intangible assets, such as research and development, brand equity, and human capital, poses a challenge to traditional earnings analysis. Accounting standards often require expensing these investments immediately, distorting reported earnings and making them less representative of a company's future earnings potential. This trend, accelerated by the COVID-19 pandemic, has increased economic volatility, adjustment speed, and scalability, further emphasizing the need to look beyond reported earnings and assess the sustainability of a company's business model.
The Growing Use of Quality Factors in Investment Strategies: While "quality" has become a popular factor in risk models and investment strategies, its definition and measurement are often arbitrary and prone to data mining biases. Many quality factors lack a robust theoretical foundation, making them less reliable. Professor Nissim advocates for a deeper understanding of accounting and economic relationships to develop more meaningful quality indicators and avoid potentially misleading signals.
II. Key Indicators of Earnings Quality
Investors can use various financial and non-financial indicators to assess earnings quality. Here are some important categories:
Comprehensive Indicators
Accruals: The difference between net income and cash from operations. High accruals can signal aggressive accounting practices.
Profitability Analysis: Decomposing return on equity (ROE) and other profitability ratios into their drivers (profit margin, asset turnover, leverage, etc.) can reveal insights into the sustainability of earnings.
Line-Item Indicators
Days Sales Outstanding (DSO): A measure of how long it takes a company to collect receivables. Abnormal increases in DSO can suggest revenue manipulation.
Inventory Turnover: How quickly a company sells its inventory. Slowing turnover could point to an overstatement of inventory.
Non-Financial Indicators
Governance Structure: Strong corporate governance can help prevent earnings manipulation.
Management Incentives: Investors should be wary of companies with aggressive earnings targets or compensation structures heavily tied to short-term earnings performance.
Economic Environment and Industry Conditions: Earnings quality can be affected by factors like industry cyclicality and overall economic conditions.
And I can't stress it enough: contextual analysis is key.
It's crucial to analyze earnings quality indicators in context. No single indicator is foolproof, and any red flag can have alternative explanations. Investors should consider multiple indicators together and consider company-specific factors like business models, industry, and management incentives.
Earnings quality is a critical but often overlooked aspect of investment analysis. By developing a deep understanding of earnings quality and the factors that drive it, investors can avoid pitfalls and make more informed decisions. Remember: high-quality earnings are the foundation of a sustainable and valuable business.
III. Distortion In Earnings Quality
In addition to the increased volatility in earnings caused by the shift in accounting standards and the nature of intangible assets, Professor Nissim identifies the distortion created by the immediate expensing of intangible investments as a factor that further erodes earnings sustainability.
While accounting standards have shifted towards emphasizing balance sheet measurements at fair value, the immediate expensing of intangible assets continues to create a mismatch between the timing of costs and benefits in the income statement. This disconnect can lead to an understatement of earnings in the period of investment and an overstatement in subsequent periods as the benefits of those investments are realized.
This distortion is further exacerbated by the increasing importance of intangible investments in today's economy, where intangible assets, such as R&D, brand equity, and human capital, have become crucial drivers of value creation.
As a result, the sources argue that relying solely on reported earnings may not accurately reflect a company's true earnings power or its ability to generate profits consistently in the future. Investors need to look beyond reported earnings and consider the long-term impact of intangible investments on profitability.
IV. Non-Financial Indicator: Meet or Beat Benchmarks
Professor Nissim discusses several non-financial indicators that provide insight into earnings quality. One specific example is whether the company is facing pressure to "meet or beat" earnings benchmarks. This pressure can create a strong incentive for management to manipulate earnings.
Several benchmarks can trigger earnings management behavior:
Positive Earnings: Companies strive to avoid reporting losses.
Year-over-year Earnings Growth: Companies face pressure to show consistent earnings growth, leading them to manage earnings to ensure they exceed the previous year's results.
Analysts' Consensus Forecasts: Meeting or exceeding analysts' earnings expectations is often seen as a sign of solid performance. Companies may manipulate earnings to avoid negative market reactions or analyst downgrades that can result from missing forecasts.
Management Forecasts: Similarly, companies are incentivized to meet or beat their own earnings guidance provided to the market, as failing to do so can damage investor confidence.
Professor Nissim suggests that when a company faces pressure to meet or beat these benchmarks, it increases the likelihood that reported earnings have been manipulated.
Context is crucial when considering this non-financial indicator. A company might legitimately miss a benchmark due to unforeseen economic circumstances. However, if a company consistently manages to narrowly beat expectations, or if there are other red flags present (such as aggressive accounting choices or unusual transactions), this non-financial indicator can provide valuable insight into the potential manipulation of earnings.
And these reasons illustrate why a company like Enron deceives investors.
Enron Corporation, originally a natural gas pipeline company, transformed into an energy giant through deregulation and aggressive trading in the 1990s. The company's rapid growth and innovative business practices, particularly in energy derivatives, attracted investors and led to soaring stock prices. However, Enron's success was built on a foundation of accounting fraud and deception, ultimately leading to its spectacular collapse in 2001.
While a few sources have outlined their manipulative schemes, they ultimately manipulate their earnings records in two main ways:
Mark-to-market Accounting: Enron exploited mark-to-market accounting rules, which allowed companies to record the value of assets and liabilities based on their estimated fair value to inflate their earnings. This approach provided significant leeway for subjective valuations and allowed Enron to book future profits from long-term energy contracts upfront, even though the actual cash flows were uncertain.
Special Purpose Entities (SPEs): As discussed in our conversation history, Enron used a complex web of SPEs to hide billions of dollars in debt and losses off its balance sheet. These SPEs, often created with the help of complicit banks and financial institutions, allowed Enron to shift risky assets and liabilities, making its financial position appear stronger than it actually was.
V. The Three Drivers of Operating Profitability
Professor Nissim's profitability analysis framework, specifically for operating profitability, is built around decomposing the commonly used Return on Net Operating Assets (RNOA) into three key drivers. This approach aims to provide a more nuanced understanding of a company's ability to generate profits from its operations and offer insights into earnings sustainability.
The three drivers are:
Operating Profit Margin: This measures how much profit a company generates for every dollar of revenue. It is calculated as NOPAT (Net Operating Profit After Tax) divided by operating revenue. A higher operating profit margin suggests the company effectively manages its costs and pricing its products or services.
Operating Asset Turnover: This ratio measures how efficiently a company utilizes its operating assets to generate revenue. It is calculated as operating revenue divided by average operating assets. A higher turnover ratio indicates the company is effectively deploying its assets to generate sales.
Operations Funding Ratio: This unique element in Professor Nissim's framework captures the impact of operating credit on profitability. It is calculated as average net operating assets divided by average operating assets. This ratio essentially shows the proportion of operating assets funded by debt and equity capital versus operating credit from suppliers, customers, employees, or other stakeholders. A higher operations funding ratio indicates a greater reliance on external financing and less on operating credit.
Professor Nissim highlights several advantages of using this three-driver framework:
Focus on Balance Sheet: The Operations Funding Ratio relies solely on balance sheet information, making it more stable over time and easier to forecast compared to income statement-based metrics.
Comprehensive View of Turnover: Using operating assets in the denominator for the Operating Asset Turnover ratio provides a more accurate representation of how effectively all operating assets are being utilized to generate revenue.
Robust Statistical Properties: The three drivers are meaningful and statistically robust even when net operating assets are small or negative, making the analysis applicable in a wider range of situations.
By analyzing these three drivers individually and together, investors can gain a deeper understanding of a company's operating performance, assess the sustainability of its earnings, and make more informed investment decisions.