Smarter Earnings

Although the scorecard on the 2003 earnings season is nearly full, investors should be careful about jumping into a stock — or dumping it — solely on the basis of a hit or miss in the last quarter. Certainly, investor confidence has been buoyed by a resurgence in profits. Corporate earnings shot up about 28% in the fourth quarter of 2003 and climbed 18% for the entire year, according to Thomson First Call.

That's remarkable compared with minuscule profit growth in 2002 and a 17% decline in 2001. But investors shouldn't focus merely on the bottom line. They need to look beyond the numbers on the balance sheet to assess the quality of earnings and determine whether a company's profitability is sustainable.

Does earnings quality count when it comes to stock performance? Absolutely. Ask David Bianco, an accounting analyst at UBS who has scrutinized earnings quality. He found that since 1998, the 50 companies with the best quality earnings have returns that were about four times that of the S&P 500 index. The bottom 50? Zero returns over the same period.

Still, many investors aren't sure how to determine whether earnings quality is good enough. Here's a checklist:

COMPARE OPERATING AND GAAP EARNINGS One way to assess earnings quality is to compare two earnings calculations that usually appear in a company's earnings release and make sure they're not too far apart. Look at operating profits (also called pro forma earnings). That number should include only net income from the company's primary business operations, and it shouldn't differ too greatly from GAAP earnings (total profits), which include special charges like restructuring and acquisitions. Those write-offs "may significantly weaken a balance sheet or impair a competitive business environment," Bianco says. "And they are likely to happen again."

The spread between operating and GAAP earnings really got out of whack from 2000 to 2002. Fortunately, the GAAP gap is narrowing. The spread was 13% for 2003, compared with an astonishing 75% in the fourth quarter of 2002, says Howard Silverblatt, market equity analyst at Standard & Poor's. That convergence bodes well for earnings quality, he says, although profits posted don't always tell the whole story.

COMPARE NET INCOME WITH CASH FLOW Cash flow is just as important in assessing quality, says Pat Dorsey, director of stock analysis at Morningstar and author of The Five Rules for Successful Stock Investing. He encourages investors to measure the trend of net income against cash flow from operations. "If net income keeps rising over time but cash flow is stagnant or declining, then the company is getting that income from noncash sources, and that's low quality," he says. Noncash sources could include the sale of an investment in another company or the divestiture of businesses.

TRACK ACCOUNTS RECEIVABLE AGAINST SALES See whether a company is actually getting paid for what it sells. If enough customers don't put up money, a firm may be forced to take a charge. It's simply not possible for accounts receivable to increase faster than sales for long, since the company would be paying out more (as finished goods) than it was taking in (through payments).

DON'T DEPEND ON THE DOLLAR Many corporations noted the impact of a favorable exchange rate on gains in their most recent earnings reports. Although the weaker dollar may have helped boost their European sales, it can't be relied on to sustain profit growth.

Finding all this information may take some digging in the footnotes of a company's 10-K form, which you can find at www.sec.gov. But having evidence that your investment is well positioned is certainly worth the search.