There is no doubting the assertion that stocks with higher earnings are more likely to outperform the market than others. But how do you determine whether a company’s earnings have some quality that might trigger investors’ demand for the stock? While actual Naira value per share informs investors how much they would be earning per share on their investment, it is not sufficient to conclude that this represents a measure of quality of earnings.
Investors have been observed to focus on actual kobo per share delivered, resulting either in share prices going up when companies beat earnings estimates, or falling when earnings come in below projection. At first glance at least, when it comes to earnings, size matters most to investors. Savvy investors, however, take time to look at the quality of those earnings. The quality rather than quantity of corporate earnings is a much better gauge of future earnings performance. Firms with high-quality earnings typically generate above-average Price Earnings (P/E) multiples. They also tend to outperform the market for a longer time. More reliable than other earnings, high-quality earnings give investors a good reason to pay more.
What are Earnings?
Earnings refer to the amount of profit a company is able to generate during a specific period, usually, quarterly, half-yearly and annually. Earnings typically refer to income that a company realizes after it must have taken out its taxes for the period. Ultimately, a business’s earnings are the main determinant of its share price, because earnings and the circumstances relating to them can indicate whether the business will be profitable and successful in the long run.
Earnings are perhaps the single most relevant figures in a company’s financial statements because they show how profitable a company really is. Usually, investors compare estimates of a company’s earnings, done through fundamental analysis, with actual periodic earnings as released by the company from time to time. It follows that decisions regarding buying, holding or selling the company’s stock are made from this comparison. In most situations, when earnings do not meet either of those estimates, a company’s stock price will tend to drop. On the other hand, when actual earnings beat estimates by a significant amount, the share price will likely surge.
What factors determine a company’s earnings?
There are several factors that affect a company’s earnings. Some of these factors are within the control of the company while some others are outside the control of the company. Let us examine these two categories of factors in the following paragraphs.
Monetary and government fiscal policies have major significance on a company’s cost of capital. Inflation appears to be a very good example in this case. Inflation can generate business uncertainty, negate a company’s accounting systems, and affect the relative prices that a company faces. As an example, consider a manufacturing company that keeps a stock of inventory, its selling prices are expected to rise with an increase in inflation rate thereby giving its earnings a boost. Inflation thus acts as a catalyst in influencing the earnings of a company.
Another important factor that influences earnings is the price of inputs and raw materials. Falling jet fuel prices, for example, can improve airline industry profits. Changes in the weather can boost earnings growth. Think of the extra profits that electrical utilities enjoy when temperatures are unusually hot or cold.
In addition, political instability or a general economic recession may significantly reduce demand for a company’s products.
Consider the effects of exchange rate changes. For example, if a company must convert its foreign currency profits back into the Naira, assuming the Naira is falling against the foreign currency, the company’s earnings will experience boost. But, management has nothing to do with those extra earnings or with ensuring they occur again in the future. On the other hand, if the Naira moves upwards, earnings growth could come in lower.
We have discussed some uncontrollable factors that affect a company’s earnings so far. Let us now shift our attention to controllable factors that have influence on a company’s earnings.
The first of this category of factors will most likely be sales, revenue or turnover. It is common knowledge that a company that records a high turnover is more likely to return good quality earnings, except of course it fails to manage its expenses properly. Investors seek companies with earnings figures that closely resemble income that is left after expenses are subtracted from revenues.
A company’s market share is also very important in analysing earnings. The market share represents the proportion of sales that the company is able to achieve relative to its competitors within the same industry that it operates. It follows that a higher market share is more likely to translate into higher earnings.
Also, capacity utilization is important in ensuring a company’s targeted earnings are met. Where the company can efficiently make use of its available resources, its earnings is more likely to record significant boost.
Perhaps the most important factor that influences a company’s earnings is the quality of management. Some critical aspects of a company’s management which every investor must consider carefully are their commitment and competence, professionalism, future orientation, image building, investor friendliness and government relation building. The future earnings of a company are very much connected with the quality and competence of its management to a very great extent.
Lastly, a company’s modernization and expansion plans also influence earnings. Some companies choose to put back some or all of its earnings into the business for future expansion. This is termed ‘plowing back’.
How to determine good quality earnings
When analyzing periodic financial reports, investors should ask themselves three simple questions concerning a company’s earnings: Are the company’s earnings repeatable? Are they within the control of the company? And finally, are the earnings bankable, that is can they be translated into cash?
We examine the above three questions in the following paragraphs:
Are the company’s earnings repeatable?
Some company’s record increased earnings by means of sale of assets, downsizing of employees and so on in order to reduce expenses. It follows that the quality of earnings realized through this approach is questionable because sale of assets is never repeatable. Once sold, assets cannot be sold again to produce more earnings and so the company would never be able re-produce such future earnings. The same applies for downsizing of employees and other such items.
Increase in sales and revenues as well as reduction in costs are the best routes to high-quality earnings. Both are repeatable. Sales growth in one quarter is likely to be followed by sales growth in the next quarter. Similarly, costs, once cut, typically remain that way. Investors are more apt to consider repeatable and fairly predictable earnings that come from sales and cost reductions.
Does the company control its earnings?
As mentioned in the preceding paragraphs, a company’s earnings could either be within or outside its control. A company whose earnings are consistently outside its control is not likely to be considered by investors since earnings follow a haphazard pattern. Cash sales – which the company does control – are the source of the highest-quality earnings; therefore investors should seek firms with earnings that closely resemble cash that is left after expenses are subtracted from revenues.
How is the company’s Cash Flow position?
There is a popular saying that “Do not count your chickens before they are hatched”. Most companies, however, enter sales as revenues, even though no money has exchanged hands. Cash payments often arrive later than receivables, so a company must wait before they can deposit revenues in the bank. The fact that customers can cancel or refuse to pay creates large uncertainties, which lower earnings quality. At the same time, generally accepted accounting principles give room for choices about what counts as reliable revenues and earnings.
Earnings per Share (EPS)
Earnings per share refer to the portion of a company’s net income allocated to each outstanding share of common stock. EPS serves as an indicator of a company’s profitability.
It is usually calculated as:
EPS = Net Income/Total Shares Outstanding
For example, assume that a company has a net income of N30 million. If the company has total outstanding shares of 15 million ordinary shares for the entire period under consideration, the EPS would be N2.00, that is, N30 million divided by 15 million shares.
An important aspect of EPS that is often ignored is the capital that is required to generate the earnings (net income) in the calculation. Two companies could generate the same EPS, but one could do so with less equity (investment) – that company would be more efficient at using its capital to generate income and, all other things being equal, would be a ‘better company’. Investors also need to be aware of earnings manipulation that will affect the quality of the EPS. It is important not to rely on any one financial measure, but to use it in conjunction with financial statement analysis and other measures.
Calculating other Earnings Ratios
Earnings Yield = EPS/Market Price per Share
Dividend Yield = Dividend per Share/Market Price per Share
Dividend Payout Ratio = Dividend per Share/Earnings per Share
Price Earnings Ratio (P/E Ratio) = Market Price per Share/EPS
Evidently, high earnings are not as important as high-quality earnings. It is important that the quality of earnings must be those which are repeatable, controllable and bankable. Earnings that experience a surge because of a one-time, uncontrollable event are not earnings that are peculiar to the activities of the business and are therefore not sustainable. These earnings are as a result of luck, which is never a reason to invest. Finally, those businesses that generate revenue but not cash are not engaging in profitable activities. When you invest, make sure your company is taking its earnings to the bank!