All Earnings Aren’t Created Equal: Judging Earnings Quality

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.

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