The phrase earnings quality is a bit of a misnomer. How is one dollar of earnings any better than another dollar? And isn’t quality subjective anyway? In last Wednesday’s issue of Small Cap Investor Daily, Finding Diamonds in the Rough, I said that in a future issue I would review two fundamental analysis metrics, earnings quality and cash flow. Today I’m digging in to the meaning of earnings quality so that you can put this fundamental analysis metric to work uncovering small-cap gems to add to your portfolio.
When I talk about earnings, I’m often referring to earnings per share (EPS), which is net income divided by the number of shares outstanding. Sometimes net income is referred to simply as profit, or even just as earnings.Simply put, earnings are a company’s net profits from operations. There are three sub-totaled line items on an income statement that you should look at:
1 Net income from operations (operating net income): This is the calculated profits including all revenues, minus direct costs and expenses related specifically to the core business. It usually excludes nonrecurring, or noncore sources of income, but history has demonstrated that some companies use a loose interpretation. More on that in a minute.
2 Net pre-tax income: This adds other income and subtracts other expenses from operating income, but it does not include the liability for income taxes. Typically, these adjustments include interest income and expense, currency exchange profit or loss, capital gains and losses, payments or receipts in settled or finalized lawsuits, and other nonrecurring, non-core transactions.
3 Net income: This takes the net pre-tax income and deducts the liability for federal income taxes (state and local taxes are already deducted in the expense section of the report). The tax hit can be a big number. As of 2009, corporations can be required to pay up to 38 percent of their net income in federal taxes.
Depending on the company you’re looking at, certain income items may be worth special consideration. For example, in last Friday’s issue of Small Cap Investor Daily, The Gig is up – This Stock’s a Winner, I reviewed Lancaster Colony (Nasdaq: LANC). Lancaster has a history of receiving cash distributions under U.S. anti-dumping law. This income is accounted for as ‘other income’, and not included as part of operating income.
So when it came time to evaluate Lancaster’s revenue and earnings growth I highlighted the fact that excluding these distributions gave a better picture of Lancaster’s true business growth. And to show how important the difference can be, I found that Lancaster actually increased net margins to 12.7% over the last year. If I didn’t break out the ‘other income’ cash distributions, it looked like the profit margin was just 7%.