Financial Accounting Blog

Wednesday, March 03, 2004

Earnings discusses Earnings Quality.
It's important to distinguish between earnings manipulation, which is done with intent to deceive, and earnings generation from low-quality sources, which won't cause a blowup, but which is still unsustainable"

The three big areas to watch are tax rates, cost-cutting, and share repurchases. Paying less in taxes to Uncle Sam is nice and does result in more money left over for shareholders at the end of the day--but what the tax code giveth, the tax code can taketh away. Tax breaks can expire or be rescinded, and there's a limit to how low a firm's tax rate can go.

Cost-cutting is similar. All else equal, I'd rather own a more efficient firm than a less efficient one, but cost-cutting has limits. At some point, all the low-hanging fruit will be plucked, margin expansion will slow, and so will earnings growth.

Finally, we have share repurchases, which, contrary to popular wisdom, are not an unadulterated positive. Firms can keep earnings per share rising at the same time they're destroying economic value by pursuing buybacks when the shares are trading at a rich valuation. In this case, the firm is overpaying for each share, which destroys value because the future return on the investment is likely to be lower than the firm's cost of capital. Since the overall share count is decreasing, however, earnings per share keep moving up.
(Posted by P. Timmerding)