It’s earnings season once again and the market is anticipating good results to sustain its uptrend.
Share prices normally go up when earnings exceed market expectations but when earning results disappoint investors, stocks usually decline on profit-taking.
Earnings are important drivers of share prices. Investors use earnings updates as basis to project how stocks are likely to be valued in the coming months.
The problem is that not all earnings share the same quality.
Because of the accounting rules that often require management judgment, some companies can apply creative techniques to show positive earnings results.
For example, a listed company can report higher quarterly revenue by simply booking additional accounts receivables to increase earnings.
Management can also choose to capitalize certain expenses to lower operating expenses and boost income.
Because the stock market tends to overvalue accounting earnings, there is a need to validate the quality of earnings that companies report by looking at its cash flows.
If you have two stocks that have similar markets and earnings growth outlook, you would always choose the one with higher cash flows because the risk is lower.
A stock that generates high cash flows at a lower risk translates to higher share price valuation.
The cash flows of a company can be broken down into three components: operating, investing and financing activities.
Among the three, the operating cash flow is considered the most important because it indicates the capacity of a company to generate cash from the business.
If a company cannot produce adequate cash flows from operations, it will not be able to finance its expansion activities unless it secures funding from outside either by borrowing or capital raising.
The operating cash flow, which adjusts accrual accounting to cash basis, is seen as a safer alternative to net income because there is less room for management to manipulate the figures.
If operating cash flow is greater than the reported earnings, it means the company has a high earnings quality that may merit a premium on valuation.
On the other hand, companies that have poor earnings quality are those that report operating cash flows lower than their accounting income.
But how reliable is earnings quality as predictor of stock returns?
Let’s say the indicator for quality can be expressed as a ratio of operating cash flow to net income so that the higher the ratio, the better the earnings.
Based on 2017 financial statements of the 30 PSE Index stocks, we can find that earnings quality has a significant correlation of 18.5 percent with stock returns.
This means that if you invest in stocks with high operating cash flow to earnings ratios this year based on the year-end financials from 2018, there is 18.5 percent chance that your investment will generate positive returns next year.
Interestingly, we can also find that stocks with quality ratios of 1.5 times and above have better chances of succeeding than those with lower ratios.
For example, the top blue-chip stocks with at least 1.5 times ratios generated a median return of positive 11.2 percent from last year while those with less than 1.5 times had a median return of negative 4.3 percent.
The first five stocks with high-quality ratios include First Gen which generated +25 percent with 4.6x, PLDT (-17 percent, 4.2x); Globe Telecoms (+20.6 percent, 3.3x); ICTSI (+17 percent, 3.1x) and San Miguel (+22 percent, 2.8x).
This is followed by Robinsons Land (+14.8 percent, 2.6x); Metro Pacific Investments (-6.9 percent, 2.0x); Jollibee (+4.3 percent, 1.8x); SM Investments (+7.5 percent, 1.6x) and Aboitiz Equity Ventures (-5.3 percent, 1.5x).
Earnings quality may be an important factor in driving stock returns but bear in mind that this is just the first step in separating the “good” from the “bad.”
While stocks may rise and fall on earnings announcement, at least in the short term, it is the quality of earnings as determined by a company’s capacity to generate cash flows that will define the value of a stock in the long term.