Thursday, 8 November 2012

How To Evaluate The Quality Of EPS and find out what it's telling you about a stock.

The evaluation of earnings per share should be a relatively straightforward process, but thanks to the magic of accounting, it has become a game of smoke and mirrors. This, however, does create opportunities for investors who can evaluate the quality of earnings over the long run and take advantage of market overreactions.

EPS Quality  
High-quality EPS means that the number is a relatively true representation of what the company actually earned (i.e. cash generated).  But while evaluating EPS cuts through a lot of the accounting gimmicks, it does not totally eliminate the risk that the financial statements are misrepresented. While it is becoming harder to manipulate the statement of cash flows, it can still be done.
A low-quality EPS number does not accurately portray what the company earned.  A reported number that does not portray the real earnings of the company can mislead investors into making bad investment decisions. 

How to Evaluate the Quality of EPS
The best way to evaluate quality is to compare operating cash flow per share to reported EPS. While this is an easy calculation to make, the required information is often not provided until months after results are announced, when the company files its 10-K or 10-Q with theSEC.

To determine earnings quality, investors can rely on operating cash flow. 
1.  Positive earnings but negative Operating cash flow.Thumbs DownThumbs DownThumbs Down
  • The company can show a positive earnings on the income statement while also bearing a negative cash flow. 
  • This is not a good situation to be in for a long time, because it means that the company has to borrow money to keep operating. And at some point, the bank will stop lending and want to be repaid. 
  • A negative cash flow also indicates that there is a fundamental operating problem: either inventory is not selling or receivables are not getting collected.
  • "Cash is king" is one of the few real truisms on Wall Street, and companies that don't generate cash are not around for long.

2.  Operating cash flow > earnings Thumbs UpThumbs UpThumbs UpThumbs UpThumbs Up
  • If operating cash flow per share (operating cash flow divided by the number of shares used to calculate EPS) is greater than reported EPS.
  • In this case, earnings are of a high quality because the company is generating more cash than is reported on the income statement. 
  • Reported (GAAP) earnings, therefore, understate the profitability of the company.

3.  Operating cash flow < earningsThumbs DownThumbs Up
  • If operating cash flow per share is less than reported EPS, it means that the company is generating less cash than is represented by reported EPS. 
  • In this case, EPS is of low quality because it does not reflect the negative operating results of the company.
  • Therefore, it overstates what the true (cash) operating results. 

Trends Are Also Important
Because a negative cash flow may not necessarily be illegitimate, investors should analyze the trend of both reported EPS and operating cash flow per share (or net income and operating cash flow) in relation to industry trends.
  • It is possible that an entire industry may generate negative operating cash flow due to cyclical causes.
  • Operating cash flows may be negative also because of the company's need to invest in marketing, information systems and R&D. In these cases, the company is sacrificing near-term profitability for longer-term growth.Thumbs Up

Evaluating trends will also help you spot the worst-case scenario, which occurs when a company reports increasingly negative operating cash flow and increasing GAAP EPS. 
  • As discussed above, there may be legitimate reasons for this discrepancy (economic cycles, the need to invest for future growth), but if the company is to survive, the discrepancy cannot last long. 
  • The appearance of growing GAAP EPS even though the company is actually losing money can mislead investors. This is why investors should evaluate the legitimacy of a growing GAAP EPS by analyzing the trend in debt levels, times interest earned, days sales outstanding and inventory turnover.

The Bottom Line
Without question, cash is king on Wall Street, and companies that generate a growing stream of operating cash flow per share are better investments than companies that post increased GAAP EPS growth and negative operating cash flow per share. 
Earnings increasing and Operating cash flow increasingThumbs UpThumbs Up Thumbs UpThumbs UpThumbs Up> Earnings increasing but negative operating cash flowThumbs DownThumbs DownThumbs Down
The ideal situation occurs when operating cash flow per share exceeds GAAP EPS. 

Operating cash flow > EarningsThumbs UpThumbs UpThumbs UpThumbs UpThumbs Up
The worst situation occurs when a company is constantly using cash (causing a negative operating cash flow) while showing positive GAAP EPS. 
Positive Earnings but negative operating cash flow.Thumbs DownThumbs DownThumbs Down
Luckily, it is relatively easy for investors to evaluate the situation. 

An Example
Let's say that Behemoth Software (BS for short) reported that its GAAP EPS was $1. Assume that this number was derived by following GAAP and that management did not fudge its books. And assume further that this number indicates an impressive growth rate of 20%. In most markets, investors would buy this stock.

However, if BS's operating cash flow per share were a negative 50 cents, it would indicate that the company really lost 50 cents of cash per share versus the reported $1. This means that there was a gap of $1.50 between the GAAP EPS and actual cash per share generated by operations. A red flag should alert investors that they need to do more research to determine the cause and duration of the shortfall. The 50 cent negative cash flow per share would have to be financed in some way, such as borrowing from a bank, issuing stock, or selling assets. These activities would be reflected in another section of the cash flow statement.

If BS's operating cash flow per share were $1.50, this would indicate that reported EPS was of high quality because actual cash that BS generated was 50 cents more than was reported under GAAP. A company that can consistently generate growing operating cash flows that are greater than GAAP earnings may be a rarity, but it is generally a very good investment.

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