Evaluation of Earnings Quality
We analyze companies’ earnings to understand the earnings quality, i.e., the persistence and sustainability of earnings. Many accounting policies demand estimations and rely on subjective decisions. Some managers take advantage of this and indulge in creative accounting to report misleading…
Sources of Information about Risk
Examining financial, operating, and other risks is an essential part of an analyst’s job. Here, we discuss sources of information about risk. Financial Statements A company’s financial statements provide useful indicators of financial, operating, or other risks. For example, leverage…
Evaluation of the Balance Sheet Quality of a Company
Recall from the previous section that high financial reporting quality of the balance sheet is stipulated by completeness, unbiased measurement, and clear presentation. The existence of off-balance-sheet liabilities (obligations) such as debts compromises the completeness of a balance sheet. Also,…
Indicators of Balance Sheet Quality
Completeness, unbiased measurement, and clear presentation indicate high financial reporting quality of the balance sheet. Moreover, a strong balance sheet has an optimal leverage amount, adequate liquidity, and economically successful asset allocation. Balance sheet strength is assessed using ratio analysis….
Evaluating the Cash Flow Quality of a Company
The cash flow statement is used to identify areas of possible earnings manipulation since OCF is viewed as less subject to manipulation relative to earnings. An analyst should check for any unusual items or items that have not been present…
Indicators of Cash Flow Quality
The operating cash flow (OCF) is the cash flow component with the most direct impact on the valuation of a company. High-quality cash flow indicates that the company’s underlying economic performance was value-enhancing. Further, it implies that the information calculated…
Mean Reversion in Earnings
Recall from the previous section that earnings at extreme levels, both high and low, tend to revert to normal levels over time, a phenomenon called mean reversion. This is a typical characteristic of competitive markets. When a company realizes low…
Indicators of Earning Quality
High-quality earnings are characterized by sustainability and adequacy. Sustainability of high-quality earnings means that they tend to persist in the future, whereas adequacy implies that high-quality earnings cover the company’s cost of capital. High-quality earnings assume high-quality reporting. Furthermore, high-quality…
Sustainable (Persistent) Earnings
Sustainable (persistent) earnings are earnings that are expected to recur in the future. Non-recurring earnings are not sustainable and thus are low-quality earnings. More persistent earnings are more practical inputs for equity valuation models involving earnings forecasts. One way to…
Examination of the Quality of a Company’s Financial Reports
The M-score is the score indicating the probability of earnings manipulation. (Refer to the previous section for analysis of the model variables.) The M-score is a normally distributed random variable with a mean of 0 and a standard deviation of…
