During earnings seasons, we are bombarded with headlines about earnings beats and misses, along with revised estimates for upcoming quarter’s results. While most investors can follow and interpret these results, truly savvy investors pay attention to the quality of earnings instead of just getting swept away with the basics.
This is especially true because earnings figures are easy to manipulate with various accounting principles. Digging deeper into the balance sheet, you’ll find metrics like cash flow and return on assets (ROA) that are difficult to manipulate and thus better reflect the quality of a company’s business and investments.
Once you establish quality, you can then use basic earnings figures to establish a fair value for it.
Let’s look closer at return on assets as an example. If you’re in the market for a high-quality stock pick, be sure you avoid companies with fixed assets and inventories that are growing faster than revenues and earnings.
Why? Well, if a company is buying a ton of inventory, for instance, and then not using it to actually produce and in turn sell product, that means it’s not being efficient with spending and is reducing working capital (like cash) to buy unnecessary things. Such a trend is also worrisome because inventory can become obsolete, and will then have to be written off as an expense on the company’s income statement if it’s old, damaged, etc.
Put another way, you don’t want a company that has a big balance sheet — specifically, a bunch of assets funded through cash outflow or debt — that doesn’t correlate with revenue and net income. You want a company that is effectively converting the money it has to invest into more income.
As Investopedia concisely and effectively explains: “Anybody can make a profit by throwing a ton of money at a problem, but very few managers excel at making large profits with little investment.”
To calculate a company’s return on assets, simply divide net income by total assets — and then look for picks that have a high ratio when you do so.
Of course, return on assets will natually vary by industry. For example, the software industry — which falls under the technology umbrella that tops the aforementioned list — has no inventory. The same holds true for royalty trusts. But inventory is an inherent part of business for retail stock and pharma stocks, on the other hand.
The point is that it’s difficult to compare software ROA to retail return on assets, as it’s really comparing apples to oranges. But if you’re eyeing an investment in either sector, definitely compare any potential picks to others in the industry and close competitors. Even in retail, quality companies will have a high ratio if they are good at managing.
For example, Dick’s Sporting Goods (DKS) boasts a return on assets of 10.37%, while retailers Abercrombie & Fitch (ANF) and J.C. Penney (JCP) get just a 3.3% and -1.09% respectively.
Hilary Kramer is the editor of GameChangers, Breakout Stocks Under $10, High Octane Trader,Absolute Capital Return and Value Authority. She is an accomplished investment specialist and market strategist with more than 25 years of experience in portfolio management, equity research, trading, and risk management. She has extensive expertise in global financial management, asset allocation, investment banking and private equity ventures, and is regularly sought after to provide her analysis on Bloomberg, CNBC, Fox Business Network, and other media.
