High quality earnings vs Low quality earnings and Accrual Ratio of Professor Sloan

 

The Simple Idea

High quality earnings = Profit that is backed by real cash and is sustainable into the future.
Low quality earnings = Profit that comes from accounting tricks, one‑time events, or non‑cash items – and may not repeat.

Think of it like a fruit tree:

• High quality = The tree produces fruit every year without extra work.

• Low quality = You borrowed fruit from next year’s harvest – looks good today, but tomorrow there’s nothing.

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High Quality Earnings – Characteristics

Feature	What it means
Cash-backed	Most of the reported profit has already turned into cash in the bank.
Recurring	Comes from normal business operations, not one‑time sales or asset sales.
Low accruals	The accrual ratio is low (close to zero or negative).
Conservative accounting	The company doesn’t stretch rules to make profit look better.
Predictable	Investors can trust that next quarter’s profit will be similar.

Example: A grocery store sells bread for cash. Every day, cash in the till matches the day’s profit. High quality.

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Low Quality Earnings – Characteristics

Feature	What it means
Not cash-backed	Profit is reported, but cash hasn’t arrived yet (or never will).
One‑time boosts	Selling a building, a legal settlement, or a tax refund.
High accruals	Accrual ratio above 0.3 or 0.4 – profit is mostly “paper”.
Aggressive accounting	Recognizing sales too early, delaying expense recognition.
Unpredictable	Next quarter’s profit could collapse when accruals reverse.

Example: A software company signs a 5‑year contract for RM1 million, records all RM1 million as profit today – but the customer pays only RM200,000 per year. The profit looks huge, but cash arrives slowly. Low quality.

How the Accrual Ratio Tells You Which Is Which

Remember the formula:

Accrual Ratio = (Net Income − Operating Cash Flow) ÷ Average Total Assets

Accrual Ratio	Meaning	Earnings Quality
Close to 0 or negative	Profit ≈ Cash flow	High quality
0.1 – 0.3	Moderate gap	Medium quality – watch carefully
Above 0.3 (e.g., 0.39)	Profit significantly exceeds cash flow	Low quality – warning sign

According to Professor Sloan’s research, such companies often see weaker future profits because the accruals eventually reverse (customers don’t pay, or bills come due).

Real‑World Example You Can Understand

High Quality Earnings – A Barber Shop

• Cuts hair for cash. At the end of the day, cash in drawer = profit.

• Accrual ratio ~0.

Low Quality Earnings – A Construction Company

• Signs a RM10 million contract. Records RM5 million profit immediately, but customer will pay over 3 years.

• Profit looks great this year, but cash is much lower.

• If the customer delays payment, profit stays on paper but the company can’t pay its workers.

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Why Investors Care

• High quality earnings → reliable dividends, stable share price, lower risk.

• Low quality earnings → risk of a sudden profit drop, share price collapse, or even accounting scandals.

Example:  Yahoo Finance flagged a company's accrual ratio of 0.39 – it’s a red flag that earnings may be lower quality than they appear.

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The Bottom Line in One Sentence

High quality earnings = profit you can touch (cash).
Low quality earnings = profit you can only see on paper (accruals) – and might disappear later.

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 Accrual Ratio 

The Standard Formula (Professor Sloan)

Accrual Ratio (standard) = (Net Profit − Net Operating Cash Flow) ÷ Average Total Assets

Example using simple numbers:

• Net Profit = RM100

• Net Operating Cash Flow = RM60

Using Average Total Assets = RM500:

Accrual Ratio -= (100 − 60) ÷ 500 = 40 ÷ 500 = 0.08 (or 8%)

“How material are accruals relative to the size of the business?”

Usually between −0.2 and +0.2 for healthy companies; above 0.3 is a warning.

Why the Standard Formula Uses Total Assets

Professor Sloan chose average total assets as the denominator to:

• Scale the accrual amount to the company’s size – a RM40 accrual matters more for a small company (assets RM100) than a giant (assets RM1,000).

• Allow comparison between different companies (small vs large).

Stick to the standard formula because it’s the benchmark for warnings (e.g., >0.3 is a red flag). 

Useful to compare across companies of different sizes

The Business of Oil Palm Estates

Here is a description of the oil palm estates business model and how its financial performance is tied to the price of crude palm oil (CPO).

The Business of Oil Palm Estates

At its core, an oil palm estate is an agricultural production and processing business. Its primary activities are:

1. Cultivation: Planting and maintaining oil palm trees on large tracts of land (often thousands of hectares). The trees become mature and produce fruit 3-4 years after planting.

2. Harvesting: Continuously harvesting fresh fruit bunches (FFB) year-round. A mature tree yields fruit every 7-10 days.

3. Milling (Critical Integration): Most large estates have their own palm oil mills located on or near the estate. The FFB must be processed within 24-48 hours of harvest to prevent the free fatty acid content from rising (which degrades quality). The mill extracts the CPO and palm kernels (PK).

4. Selling: The estate sells the CPO and palm kernels to refiners, consumer goods companies, and biofuel producers.

Key Operational Metrics:

• Yield (tonnes of FFB per hectare): Biological efficiency of the trees.

• Oil Extraction Rate (OER): The percentage of CPO extracted from the FFB (typically 20-24%). A higher OER directly boosts output without planting more trees.

• Cost of Production: Primarily driven by fertiliser, labour, and mill maintenance.

How Revenues are Affected by the CPO Price

The relationship is direct, linear, and dominant.

• Primary Revenue Driver: CPO sales account for 80-90% of a typical estate's revenue (with palm kernels making up most of the remainder). The price the estate receives for its CPO is fundamentally the benchmark CPO price (e.g., traded on Bursa Malaysia Derivatives or Indonesia’s KPB-NEW), adjusted for local quality and logistics.

Simple Revenue Formula:

Revenue ≈ (CPO Price per Tonne × CPO Volume) + (PK Price × PK Volume)

• Volume (CPO) = FFB Harvested (tonnes) × Oil Extraction Rate (OER).

The Effect:

• High CPO Price: Revenue surges. Even if production volume is flat or down slightly, high prices can double or triple total revenue overnight.

• Low CPO Price: Revenue collapses. Estates operate in a "price taker" environment; they cannot differentiate their commodity product to command a premium.

How Profits are Affected by the CPO Price (The Amplifier)

Profits are much more volatile than revenues. This is due to operating leverage: most production costs are fixed or semi-fixed in the short term.

Cost Structure (Simplified):

• Variable Costs (30-40%): Harvesting labour (often paid by tonne of FFB), transport to mill, and some processing utilities.

• Fixed/Semi-Fixed Costs (60-70%): Fertiliser (the largest single cost), land rent/management fees, labour for tree maintenance, mill depreciation, and administrative overhead. Crucially, fertiliser is applied on a fixed schedule regardless of the CPO price.

Profit Formula:

Profit = (CPO Price × Volume) - (Fixed Costs + Variable Costs)

The Effect (Amplification):

CPO Price Scenario: Doubles
Revenue Change: +100%
Cost Change: +10-20% (e.g., higher bonus pay, small variable cost increase)
Profit Change: Increases by 200-400%

CPO Price Scenario: Falls by 30%
Revenue Change: -30%
Cost Change: -5% (you can trim some labour)
Profit Change: May fall by 60-80% or turn into a loss

Specific Examples:

• Scenario A: CPO at $800/tonne. Revenue is strong. This covers all fixed costs easily, and every extra tonne of CPO sold has a very high profit margin (price minus low variable cost). Profits are exceptional.

• Scenario B: CPO at $400/tonne. Revenue is weak. It may barely cover the fixed costs (fertiliser, salaries, debt service). The variable costs now eat into the remainder. The estate can lose money even if it is operating efficiently.

The Critical "Breakeven" Point

Every estate has a breakeven CPO price (the price needed to cover all cash costs, including debt repayments). This varies widely by region and management:

• Efficient, mature estates in Malaysia/Indonesia: $350-$450 per tonne.

• High-cost or young estates (e.g., PNG, Colombia, or recently planted areas): $500-$650+ per tonne.

If the market CPO price falls below its breakeven level, the estate faces a cash loss. It must then decide whether to cut costs (reducing future yields by skimping on fertiliser) or absorb the loss.

Key Moderating Factors & Risks

While the CPO price is king, other factors significantly alter the final impact on profit:

1. Exchange Rates: Most CPO is priced in USD, but costs (labour, fertiliser) are in local currency (e.g., Indonesian Rupiah, Malaysian Ringgit). A weakening local currency lowers costs in USD terms, boosting profit margins when CPO is in USD.

2. Hedging: Large, sophisticated estates use futures contracts to lock in a CPO price months in advance. This stabilises profits but can also mean missing out on price rallies.

3. Crop Delays (The 9-Month Lag): A key biological feature. The effect of good weather or fertiliser application today affects FFB yield 9-12 months from now. Therefore, CPO prices and production volume are often out of sync. You can have high CPO prices but low production (a missed opportunity) or low prices with high production (magnified losses).

Summary: The Business in One Sentence

An oil palm estate is a high-operating-leverage business that converts biological growth and fixed costs into a commodity, making its profitability intensely and non-linearly sensitive to the global market price of crude palm oil. When CPO prices rise, estates print cash. When they fall, they bleed it, often unable to cut costs fast enough to keep pace

Buffett: A great company has a high return on tangible asset and is growing.

 

Here is a detailed summary of the video transcript from 0:00 to 5:47, broken down by topic.

Opening: The Car Dealership Announcement (0:00–0:26)

The speaker (Warren Buffett) starts by referencing a recent announcement: Berkshire Hathaway is buying Van Tuyl Group, the fifth largest auto dealership network in the U.S. He acknowledges that some people view the car business as "ethically challenged" but asks Buffett to explain what makes a business "good" by his standards, and why car dealerships fit that description.

Buffett’s Definition of a Good Business (0:26–1:28)

• Core trait: A good business earns a high rate of return on tangible assets.

• Best case: Businesses that earn a high return on tangible assets and grow.

• Still good: Even businesses that don't grow can be good investments if they earn a high return on tangible assets and you don't overpay.

• Key warning: Paying too much turns a good business into a bad investment. Paying an appropriate price allows you to do "all right."

• Past mistake: Buffett admits that for 20–30 years, he tried buying bad businesses at very cheap prices — and eventually learned that was a bad idea.

Why Car Dealerships Are a Good Business (1:28–2:33)

• Low capital requirements:

  • No significant receivables.

  • Inventory is financed (floor planning).

  • Real estate can be leased (though Berkshire owns 95% of theirs).

• High volume, narrow margins, high return on capital: Van Tuyl has 78 dealerships averaging over $100 million each in revenue. You can operate on thin margins but still achieve a high return on capital because very little capital is tied up in the business.

• Industry consolidation: There are over 17,000 car dealerships in the U.S. today, down from ~30,000 40–50 years ago. The average dealer does far more volume than in the past.

Big Banks: Are They Still a Good Business? (2:33–4:09)

• Are banks as good as they were a few years ago? No.

• Why the change: Banks earn on assets, not net worth. Regulations have changed to require more net worth per dollar of assets. If you earn the same amount on assets but have more net worth, your return on net worth goes down.

• Past profitability: 10–15 years ago, the better banks were "ungodly profitable" because they had very high asset-to-net-worth ratios. Some even cheated with off-balance-sheet vehicles (e.g., Citigroup) to control more assets.

• Now: Those practices are terminated. Limits on asset-to-net-worth ratios are much lower. Bigger banks have even lower allowed ratios.

• Conclusion: What was a "very profitable" business has been downgraded to a "good business" — if executed well.

How Banks Make Money & Their Fatal Flaw (4:09–5:47)

• Simple business model: Get money very cheap. Wells Fargo has roughly $1 trillion in deposits costing about 10 basis points (0.1%).

• Where banks get in trouble: Never on the liability side (deposits) or expense side — always on the asset side (what they lend/invest in).

• The core danger: Banks go "crazy" by copying what their dumb competitors are doing. This happens in every business but is "particularly virulent" in banking.

• John Stumpf quote (former Wells Fargo CEO): "I don't know why we keep looking for new ways to lose money when the old ones were working so well."

• Buffett's management rule: If someone says "we should do this because the other guy is doing it," he tells them to go back to square one.

• Anecdote: At a director's meeting, a well-known property-casualty insurance manager was trying to justify buying a life insurance company with weak reasons. When the audience wasn't convinced, he finally said, "All the other kids have one" — a common, flawed rationale for business decisions.

What moves the stock prices? Short-term noise is largely unpredictable, while long-term fundamentals have some predictive power.

 

Brian Feroldi

This chart does a great job illustrating a core principle of investing: short-term noise is largely unpredictable, while long-term fundamentals have some predictive power.

Here’s breakdown and commentary by AI.

The Big Picture: What This Chart Gets Right

The central message is sound. In the short run, markets are driven by sentiment, liquidity, and random events—none of which are consistently forecastable. In the long run, cash flows (revenue, profit, dividends) drive returns. That’s not just opinion; it’s backed by decades of academic finance.

Short-Term: Mostly "No" – And That’s Honest

Marking almost everything short-term as "No" is refreshingly realistic. Things like:

• Media coverage, Fed news, CEO tweets, black swans – truly unpredictable in timing and market impact.

• Insider buying/selling – often cited as a signal, but studies show it’s weak for short-term timing. Insiders sell for many reasons (diversification, liquidity), and buying can be opportunistic but not reliably front-runnable.

The only "Sort of" in short-term is Public Investor Presentation. That’s interesting. I’d argue it’s still mostly unpredictable, because how the market interprets the presentation depends on prevailing sentiment. But you could defend this: a clear guidance change or capital allocation plan can move a stock predictably if it’s a true surprise. Still, "sort of" feels generous.

Missing short-term factors that are somewhat predictable:

• Seasonality (e.g., "Santa Claus rally," January effect) – weak but non-zero predictability.

• Options expiry / rebalancing flows – these are scheduled and can cause short-term moves.

• Earnings announcement dates – known in advance, though the direction isn’t.

But overall, the short-term column is a healthy antidote to the noise traders and pundits who pretend otherwise.

Long-Term: "Yes / Sort of" – Reasonable but Needs Nuance

Revenue and profit growth over many years are indeed the main drivers of stock returns. But the chart glosses over two key issues:

1. Valuation matters. You can have great profit growth but still lose money if you bought at an insane multiple (see: Cisco in 2000, many EVs in 2021). The chart doesn’t mention starting valuation – which is somewhat predictable in its long-term effect (high starting yields → lower future returns).

2. Growth itself isn’t perfectly predictable even long-term. Mean reversion in profitability is strong. Most high-growth companies slow down. So "Yes / Sort of" is fair – you can make reasonable forecasts, but they’re often wrong.

Dividends – yes, more predictable than price changes, but cuts happen. Dividend aristocrats are relatively stable, but not risk-free.

What’s Curious: Items That Stay "No" in Long-Term

The chart keeps Media Coverage, Short Seller Reports, Economic Data, Fed News, Insider trades, Guidance, Acquisitions as "No" in long-term as well. That’s mostly correct, but with a caveat:

• Economic data – long-term trends (e.g., productivity growth, demographics) are somewhat predictable and matter for market returns. The chart seems to treat economic data as monthly releases, which is fair. But if they meant long-term economic trends, I’d argue "Sort of."

• Acquisitions – long-term, most destroy value for acquirers. So predicting that an acquisition will help a stock is hard. Marking "No" is right.

A Subtle Inconsistency

The chart implies that short-term Public Investor Presentations are "Sort of" predictable, but long-term they become "No." That seems backwards. If a presentation reveals a credible 5-year plan, shouldn’t that be more informative for long-term? Possibly they mean: in the short run, a single presentation can trigger a move (predictably if it’s a big surprise), but over long time horizons, any single event gets washed out. That’s defensible.

Final Verdict

Usefulness: High – especially for newer investors who chase headlines or try to time Fed meetings. It’s a great visual reminder to focus on what’s actually forecastable.

Limitations: It’s binary in a gray world. "Sort of" does a lot of heavy lifting. Also, it ignores valuation and starting yield, which are among the most predictable long-term return drivers.

One-liner takeaway:

Stop trying to predict the unpredictable (short-term noise). Spend your energy on reasonable long-term forecasts of cash flows – and pay attention to what price you pay.