The Impact Of The Quality Of Earnings On Valuing Companies by Olstein Funds
The Importance of Error Avoidance
A fundamental premise of the Olstein investment philosophy is that there is a strong correlation between above-average performance and error avoidance. We believe that in order to achieve long-term investment success, an investor must first consider the financial risk inherent in each investment opportunity before considering the potential for capital appreciation. Thus, when considering any security for the portfolio, we analyze the downside risk before assessing upside potential. Our assessment of downside risk starts with an analysis of a company’s quality of earnings. We assess the quality of a company’s earnings by answering three important questions:
- Do financial statements and other filings allow us to understand the reality of the company’s unique business fundamentals, competitive edge and ability to generate free cash flow?
- Does company management engage in conservative or aggressive accounting practices?
- Is all material information necessary to evaluate the company properly disclosed?
We define a high quality of earnings by how realistically we believe a company’s financial statements portray what is taking place within the business (especially within the company’s core business operations) and how accurately the financial statements characterize the sustainability of the company’s earnings from operations.
GAAP-Based Earnings vs. Economic Reality
To understand why the quality of earnings is important to estimating the value of an equity security, it is important to understand the philosophy and mechanics of the current system of corporate accounting. An equity security is worth the discounted value of the future expected cash earnings to be generated by the underlying company. However, Generally Accepted Accounting Principles (GAAP) requires that a company report earnings based on an accrual accounting. The first premise of accrual accounting states that revenue is recognized when a transaction occurs in which value has been exchanged. The revenue recognition may lead or lag the passing of cash. The other basic premise of GAAP accrual accounting is that the cost of a transaction should be recognized over the same period of time that the revenue associated with the cost is generated. The cost or expense recognition also may lead or lag the passing of cash.
Eliminating Management Bias in Financial Reporting
In reporting GAAP-based earnings, companies are given wide discretion within the rules. Some companies make conservative assumptions, while others are overly aggressive, which can produce widely differing results depending how management sees the future. In our opinion, most companies engage in some type of earnings management. It is an investment analyst’s job to determine the economic realism of management’s assumptions and to eliminate management biases by making the appropriate adjustments to reported earnings data. We believe there is nothing wrong or illegal about earnings management within limits. However, some companies exceed acceptable limits, and while their financial statements may be in accord with GAAP, they may not concur with economic reality. It is in management’s best interest to report the best earnings possible to preserve financing alternatives, keep their stock options valuable and exercisable, and to keep shareholders happy through increasing stock prices. Thus, when management identifies problems it deems to be temporary, it has the option to adopt more optimistic assumptions. The optimism could result in income being recognized more rapidly because reserves are lowered or depreciation has been lengthened (over more years). The end result is that the reporting of an earnings disappointment is virtually eliminated under the belief that short-term problems will soon end. Unfortunately, in many cases, the future earnings disappointment that has been temporarily shelved becomes larger as the optimistic assumptions can no longer be justified. Although earnings management is an everyday occurrence, this process makes it difficult to get a clear picture of the company’s basic business without performing an intensive, inferential analysis of financial statements. So even under GAAP, a true measure of the earnings power of a firm’s basic business can be distorted based on management’s biased view of reality.
Although there has been a vast improvement in the disclosure practices of public corporations over the past thirty years, the financial reporting system can always use additional improvement as new business practices evolve. However, it is important to note that all reporting systems rely on management judgment, leaving room for potential abuse or unrealistic assumptions. Improvement in disclosure practices over the past thirty years has made financial statement analysis more difficult and time consuming. Today a wealth of additional information, not available 30 years ago, is contained in the footnotes and management discussions in annual reports for anyone who wants to read with a skeptical eye. In order to value a company correctly and at the same time play defense as an investor, it is important to analyze and sort through the new information and adjust reported earnings to reflect economic reality. It is just as important to assess whether or not all the necessary information has been disclosed to properly assess a company’s free cash flow.
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