Garbage in, garbage out.

It’s a phrase typically used when talking about forecasting. Because it’s such a subjective art, your forecasts are highly dependent upon the assumptions you make.

Lowering or increasing growth assumptions, discount rates and margins can drastically change what a financial model spits out. Hence, if your assumptions are garbage you’ll get a garbage valuation.

Like I’ve mentioned before, there’s nothing wrong with creating financial models and forecasts. You’ll gain an intimate knowledge of all three financial statements and how they work together if you model them yourself.

But remember forecasts and models are far from perfect.

And that’s businesses are not static, like financial models. They’re constantly changing as their industry, business cycle, regulation and consumer tastes change.

It’s why you should even be wary of the figures presented in an annual report.  Accountants and auditors are paid to present businesses in the best light possible. So if there is a chance to artificially increase earnings out without breaking any rules, they’re going to do it.

It’s why hundreds of books, research papers and seminars are dedicated to the subject of earnings quality – finding out the real earnings of a business.

The Research Says to Look at Cash

If it wasn’t already obvious, the following CFA paper explains why assessing the quality of earnings is so important.

Certainly, everyone is aware that earnings numbers can be manipulated. Thus, some practitioners have taken the position that they will focus only on the cash flows and perform their intrinsic value analysis based on those numbers.

Earnings, and the underlying subjective assumptions, are irrelevant. I think earnings quality analysis works so well because, despite the shortcomings of earnings, the bulk of the market is looking at earnings. If you had a crystal ball that allowed you to look at the value of one variable (other than stock price) one year or one quarter from now, your best pick would be earnings.

But how bad can it be to follow accounting earnings. Surely management doesn’t mislead investors and shareholders with the figures they report?

Well, according to a 2012 paper, ‘Earnings Quality: Evidence from the Field’ that’s exactly what they do. The paper surveyed 169 CFOs of public and conducted in-depth interviews with 12 CFOs about earnings quality.

They found 50% of earnings quality was driven by non-discretionary factors. And around 20% of firms also manage earnings to misrepresent economic performance. As you can imagine over time, misleading earnings can lead to horrible performance. Sometimes it can even lead to investors buying into companies about to file for bankruptcy.

So how do you get around accounting earnings to see what a business actually earns?

In his 1996 paper, ‘Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings?’ Richard G. Sloan concluded:

The persistence of earnings performance is shown to depend on the relative magnitudes of the cash and accrual components of earnings. However, stock prices act as if investors fail to identify correctly the different properties of these two components of earnings.”

He’s essentially telling investors to look at cash flow. If operating cash flow far exceeds accounting earnings, then there’s a good chance that you’re looking at ‘quality earnings’ which will persist into the future.  What’s more, Sloan says the market doesn’t regularly identify which businesses have high equality earnings and those that don’t.

Therefore, just by knowing what to look for – businesses with high quality earnings – you can generate satisfactory returns when those earnings are recognised.

Take a look at the graph below provided by Sloan’s research. It shows the calendar year returns of a hedge fund that bought stocks with high quality earnings and also short sold stocks with low quality earnings.

Other than in 1966 and 1981, the portfolio made money each year. ‘…the average of the 30 yearly returns corresponds to the hedge portfolio return of 10.4%,’ Sloan writes.

The hedge portfolio return is positive in 28 of the 30 years examined, illustrating that the relation is fairly stable over time. The only exceptions are 1966, when the return was -19.5%, and 1981, when the return was -2.2%. The fact that the returns are positive in over 90 percent of 30 years examined helps rule out risk-based explanations.”

But rather than spit out theory, why not look at real world example of the importance of earnings quality.

One Time Fad

Enter Krispy Kreme Doughnuts, who is now a part of JAB Beech.

Remember when people were lining up just to get one of these delicious treats? I do. But what you might not remember is the huge losses they reported from 2005 to 2008.

According to Sloan who wrote about donut business in 2006, they were simply using the wrong depreciation method. And you would have found that out if you paid attention to the quality of their earnings. Sloan writes:

Krispy Kreme invested heavily in doughnut making equipment and used the straight-line method to depreciate this equipment over a 10–15 year useful life. For Krispy Kreme, this was the wrong way to depreciate.

I do not have any qualms with the useful life in terms of how long the machines will physically make doughnuts. But to me, this product seemed like a fad. Remember that when Krispy Kreme first opened new stores, people would form lines outside to purchase the doughnuts. Krispy Kreme would broadcast this phenomenon in press releases, and in the early days, the stock price would go higher.

But clearly, it was going to wear off fairly quickly. Certainly, people would not be forming lines outside two or three years after a store opened, which is what happened. Krispy Kreme would never have booked a profit had it used an accounting policy that frontloaded the depreciation and matched it to the cash flows that the doughnut machines generated.

Had you come to the same conclusion, you might have gotten out of the stock when it was trading above $45 per share. Yet, many investors weren’t so lucky. The graph below shows Krispy Kreme’s significant fall after investors woken up to amazingly huge losses.

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