Views on Life & on Equity Investing

Wonder, Wealth & Abundance

QoE over RoE

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ROE is a derivative of the Balance Sheet and Profit and Loss statement, an important metric, which along with the Cash flow statement must be studied for long term investing decision, over the heavy emphasis on Profit and Loss statement.  QOE (Quality of Earnings) trumps other metrics but there isn’t a ready made formula.

“If the company were a person, Cash Flow statement would be the index of his habits, Balance Sheet the stock take of his character and Profit and Loss statement his day to day activities.” – Feeling poetic, quoteic here.

So, don’t be fooled from the day to day activities (P&L), a person may be visiting  liquor store daily before work for reasons not at all related to alcohol addiction.

When you analyse a company to hold for the long term you need to look at dozens of things or hundreds if you have an elaborate checklist. Whilst I do that, I don’t like to boil it down to formulas like Altman Z scores and the like.

Actually, in this post, I wrote that you should have FOUR Convincing Reasons, why you bought a stock, https://lifeandequities.wordpress.com/2016/03/06/investing-rules-maximise-money-per-hour-of-research/ It can be hard indeed to find multiple reasons to invest in a company.

Analysing numbers can give you reasons. You need to stay with the questions longer to get the answers, not surprised that Einstein said he found more answers while doing menial chores than sitting on his table.

High level determinants for good QoE are:

  • Recurring vs non-recurring
  • Cash vs non-cash earnings, growing inventories, more than sales growth etc. are bad so are increasing DSO
  • Certainty and prospects of current earnings
  • Dividend payouts matter (free cash flows & intentions of management & requirements of business for expansion).
  • How the company treats one offs and non operating income
  • Shareholder’s earning vs GAAP earnings

In this paper Anup has concluded that the earnings quality has deteriorated over the previous 40 years.

https://www.sciencedirect.com/science/article/pii/S0165410114000135

The properties of earnings have changed dramatically over the past 40 years. Prior studies interpret this trend as a decline in earnings quality but disagree on whether it results from changes in the real economy or changes in accounting standards. I find that each new cohort of listed firms exhibits lower earnings quality than its predecessors, mainly because of higher intangible intensity

An intangible-intensive firm is likely to display high volatility in its revenues and cash flows because intangible investments carry higher uncertainty about future benefits than do tangible investments. By the outset of the twenty-first century, the United States had moved from being primarily an industrial economy to becoming mainly a knowledge-based economy. As a result, U.S. firms have increased their investments in intangible capital such as innovation, advertising, information technology, human capital, and customer relations.

Highlights

  • Each new cohort of listed firms uses higher intangible investments.
  • Earnings quality is negatively associated with intangible intensity.
  • Thus, each new cohort of listed firms exhibits lower earnings quality.
  • The average earnings quality of listed firms declines over time.
  • This trend is mainly due to the inclusion of newly listed firms in the firm sample.In this paper Anup has concluded that the earnings quality has deteriorated over the previous 40 years.

Some other points to ponder from KPMG checklist:

  1. Cash earnings Recurring sales for which cash has been received.
  2. Based on fixed and certain amounts from completed transactions Recurring sales of tangible delivered products.
  3. Result from consistent application of accounting principles Consistent application of LIFO method of inventory valuation.
  4. Result from consistent application of estimation principles and methods Consistent application of pension expense calculation assumptions
  5. Result from estimates for which the range of possible balances
    is relatively small
  6. Changes in the accounts receivable reserve that has a range for the possible balance
  7. Based on transactions that are recurring Rental income
  8. Result from arm’s-length, commonly executed transactions with independent
    parties
  9. Sales to an independent customer
  10. Result from assets or liabilities recorded at cost Interest on investments
  11. Reflect proposed external/internal audit adjustments as presented in the
    financial statements
  12. Repairs and maintenance expense that reflects the recording of
    external auditor adjustments for expenses that were originally
    capitalized
  13. Noncash earnings Goods sold in exchange for stock of another company
  14. Based on amounts subject to change due to changes in estimates and future
    market conditions
  15. Mark-to-market derivative contracts
  16. Result from discretionary changes to existing accounting principles that result
    in earnings but no cash increase
  17. Switch to the FIFO method of inventory valuation

There is a reasonable book on this topic called by the same name called Quality of Earnings from Thornton O’Glove

https://www.amazon.com/Quality-Earnings-Thornton-L-Oglove/dp/0684863758

In my long term investment I do care about cash flows, dividends, reported sales and reported profits in that order.

Written by amitdipsite

March 18, 2018 at 1:37 am

Posted in Uncategorized

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  1. […] QoE over RoE (Life, equities & Investments) […]


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