When stock investors are searching for potential companies to own, it is important to understand the quantity of earnings a firm is generating in order to value its businesses. While it is important to investors to see a company grow its earnings, a savvy investor would like to feel confident that the company’s earnings are repeatable and accurately represent the company’s operations.
Understanding the quality of a company’s earnings can have a great deal of influence on whether investors can have confidence in their projections of the company’s future performance. One way in which we determine the quality of a company’s earnings is to understand the level of accruals the company has on its books. If a company has an extremely high level of accruals relative to its industry peers, it is likely that the company will not receive full payment from all customers, which leads to potential poor earnings quality. Our studies show that companies with a high amount of accruals have proven to encounter far more negative earnings surprises and inferior returns than firms with lower levels of accruals.
Accruals are the difference between Cash Flow and Net Income, essentially the percentage of net income which is owed to a company from their customers (accruals), to what they have already received in cash. By avoiding companies with high levels of accruals, you can eliminate some of the possibility of owning a company that may misrepresent its ability to continue to generate earnings growth.
The Applied Finance Group’s Earnings Quality metric provides our clients a way to filter out companies with the highest levels of accruals from their list of constituents. As you can see in the charts below, we have broken down the Russell 1000 Index into quintile buckets based on accrual levels. The F rated firms have the highest level of accruals (lowest quality of earnings) and the A rated firms have the lowest level of accruals (highest quality of earnings). Both Year to Date (12-27-13 to 7-15-14) and since we began tracking the performance of this metric (1998-2014), you can notice a distinct trend that by avoiding the companies with the highest level of accruals you will avoid many torpedo stocks. This metric helps investors avoid companies that are the most likely to encounter negative earnings surprises and most likely to underperform peers with higher quality earnings.
A company with poor EQ does not necessarily mean a company is not an attractive investment opportunity as other metrics such as valuation, momentum and other quality metrics need to be taken into account. This list does serve, however, as a list of companies that contain characteristics found in companies that tend to underperform. Below we have provided a table of companies from the Russell 1000 index that have the highest level of accruals that should be monitored closely before owning.
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