- Paperback: 224 pages
- Publisher: Free Press (1 October 1998)
- Language: English
- ISBN-10: 0684863758
- ISBN-13: 978-0684863757
- Product Dimensions: 15.2 x 1.5 x 22.9 cm
- Average Customer Review: 5.0 out of 5 stars See all reviews (2 customer reviews)
- Amazon Bestsellers Rank: #64,150 in Books (See Top 100 in Books)
Quality of Earnings Paperback – 1 Oct 1998
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The chapter dealing with Non-Recurring Earnings asks what should be done with Investment or Interest Income, are they part of operations or are they not? -- O'glove teaches how to look at earnings from Major Retailers and find that on 24% came from income other than what was sold in stores, and then poses the question about whether this should be included or excluded from the Bottom Line when analyzing whether the company is a good investment.
The chapter dealing with items on the Balance Sheet, particularly accounts receivables and inventories. O'Glove teaches to look inside the inventory balance and find what contributes to that number, and analyze whether that inventory balance is due mostly to finished goods sitting on shelves, signaling future problems with slowing sales or write-offs. O'Glove uses the example of Apple under John Scully in 1985, when its finished-goods inventory nearly tripled from the prior year and Scully explained the subsequent rally resulting from better inventory turnover.
The chapter on Dividends and Share Buybacks explains how increasing a dividend payout can subsequently lead to a worse return for shareholders than if the company performed share buybacks of common stock. The illustration of Wester Union is an example of companies becoming locked into paying dividends rather than a more efficient return to shareholders.
BOTTOM LINE: O'Glove teaches an analytical approach that requires work, but applying these lessons properly can make the difference between investing in the next WorldCom or the next Apple. Fortunately, O'Glove lessons have been converted into an Excel Spreadsheet by engineer Jae Jun at his Old School Value (OSV) website. The financial statement data comes directly from Morning Star, the proprietary algorithms are 100% transparent and all the tools focus on finding out what happens at the Publicly Traded Company Behind the Scenes. Once you become familiar with the Spreadsheet, modify to fit your needs, observe whether companies use GAAP tricks to brighten their earnings ... All this automated into a Spreadsheet that cuts down analytical time to 10 minutes at the most, allowing you to save time and read the Annual Report footnotes of worthwhile companies.
The first 70 pages (out of 190 total) discuss various qualitative factors, such as not trusting analysts, reading carefully the shareholder letters to evaluate management, taking note of non-recurring expenses, etc. All fine, but also all pretty basic stuff that the serious fundamental investor already knows to do. Nothing new or eye-opening here.
Chapter 7, on tax reporting vs. shareholder reporting, was refreshing to see, as the author discusses the differences between the two, which could be substantial. However, as the author himself notes, tax reporting is only available to investors who own a significant stake in the company (greater than 5%), making it nearly impossible for the individual investor to obtain that type of information. So while the section was interesting, it's ultimately useless for most of the audience.
The real meat and bones is chapters 8 and 9, which deals with Acct. Receivable, Inventory, Debt, and Cashflow analysis. This was why I got the book in the first place. Yet even here, I was pretty disappointed. The author instructs to follow A.R. and inventory trends, and discusses positive and negative inventory divergence, and the importance of days sales in A.R., all are very useful. However, he doesn't mention how to calculate days sales in A.R., and completely omits other valuable calculations, including the days payable outstanding, the cash conversion cycle, etc. Basically, the chapter boils down to "watching bulging A.R. and inventories."
Chapter 9 offers very little in terms of debt and cashflow analysis. He gives three capital structure formulas that are found in any undergrad finance textbook (LT debt to equity, Total debt to equity, and Times interest earned), without saying much on what's a healthy D/E ratio, what level signals danger, what's a solid times interest earned multiple, etc. Again, in a nutshell down to "make sure the company has enough earnings to pay the interest on its debt." Despite the title of the chapter, there is almost NO discussion on the quality of cashflows, only that CFFO (on the cash flow statement) and free cash flow are not the same thing. Really basic stuff. A side complaint: as far as the quality of a firms earnings is concerned, the capital structure (which makes up the majority of the chapter) is largely irrelevant. While the capability to pay the interest payments are important for the health of the firm, it has no bearing on the actual "quality" of the earnings. The same can be said for the next chapter, which discusses dividends.
The remaining chapters touch on more qualitative measures, such as accounting changes, "big baths," etc. Useful material, but again, stuff most investors with a decent background already know.
Over all, I was let down big time. The biggest disappointment was the lack of any mention of accruals beyond A.R. and inventory. Yes, they are a huge part of accruals, but the author simply mentions how to analyze them by themselves, without any discussion on how to separate the accruals in the earning numbers from the cash numbers to determine the true "quality" of the earnings.
I would recommend this only if you're just venturing out to learn about "quality of earnings." If your new to this subject, read this first to get a foundation for the subject, and then pick up "Financial Shenanigans" and then "What's Behind the Numbers," which goes into much more detail about accruals, their impact on earnings, and how you can compare different FCF margins to net profit margins to better determine the "quality" of a company's earnings.
I'm about 75% done reading QofE and I felt compelled to make a recommendation because I find that the tools O'glove outlines for determining true earnings to be quite helpful. Thus far I have learned about some of the conflicts of interest that exist between major investment banks and their equity analysts (they rarely give 'sell' ratings for fear of losing valuable business), as well as some insightful analytic tools such as adjusting earnings for non-operating & non-recurring charges, hidden tax benefits, inventory and AR management, and more. The book still has much more to teach me and I'm glad I bought it. QofE is full of real world examples from the 1980's and the author asserts that an astonishingly high percentage of analysts are lazy and would avoid all kinds of trouble if they utilized some of the fairly straight-forward techniques outlined in this book.
In my opinion, you can't get a better education on the subject for $11
I would reccommend this to any serious investor without the slightest doubt that it would improve his understanding of companies and their value, other than those persons who are already conversant with examining financial reports in depth. But even they might gain from it.
I shall definately return to read chapters of this book again.
of accounting -- such as the timing of receivables, depreciation, and writeoffs --
which are all perfectly legal and standards accounting choices -- collectively
make a big difference in reported earnings. As a result, to make a truly
well-founded judgment, you would have to dig down into the 10-K to figure out
the "quality" of earnings -- i.e. you would have to correct the work of the company's
accountants to a "standard" standard before believing it.
It is good to read it together with "The Art of Short Selling (A Marketplace Book)
by Kathryn F. Staley, which is even more amusing to the point of being biting.
Both are excellent.
Staley: Acid and cutting. Her companies don't just bend the rules, they break them.
A lot of them file for bankruptcy while she is shorting them.
O'glove: More subtle. His companies only shade the earnings. So they're off
by 15%, or 37%, i.e. the company isn't quite worth its price, that's ll.