Many of the companies having smart enough management who know that analysts and the majority of investors focus on the bottom line so that they also emphasize the boosts earning at any means. Manipulating earnings for the few years can reward them a better way by offloading their stakes. Thus, we require to study earnings quality by putting a huge emphasis.

I have a different series under the “Simple is Better” category which covers tricks to identify earning manipulation.

Management of companies can be hungry for getting recognition which makes them involved in the playing with the earnings. We should not focus on the short-term earnings or one year earning for deciding for investment purpose otherwise we can be stuck into the trap. We need to focus on the footnotes for understanding properly for onetime earnings. Whether such earning will be going to recurring or one time? We also can perform an adjustment to the one time earning and need to check that still stock available at cheaper multiple or not. Does the company involve the frequent selling off assets for boosting profits? Does Company has change revenue recognition policy, change other accounting policy? Does the Company involve accounting shenanigans? When things available at dirt cheap then first need to check it thoroughly that why such cheapness is available with the stock. Cheapness is attractive always but the reason behind cheapness is an important factor.

One of the exchanges

The company got other income due to stake sell into the subsidiary company which has boost earning by ~3x and due to such one-time earning P/E multiple has fallen drastically. And, this fallen P/E multiple misguide investors and attract them to make a mistake.

We have to remove the effect of one time gain in the normal business and need to take an average of the 10 year or entire cycle for elements temporary and extreme profitability effects.

One of the automobile company has a reverse of the provision made during a slowdown time

If businesses into the cyclical nature then it is advisable to take an average of past seven to ten years or a business cycle earning average for nullifying the effects of ups and downs into the earnings due to changes into the cycle. If we focus on the earning at the best cycle then we can attract to buy and end up with the losses or has to wait till the next good time of the cycle. Reversely, when we focus on the worst cycle then we avoid the opportunity and we end up with the opportunity miss.

Example of the cyclical company regarding buying at top of the cycle which resulted in losses and the bottom of the cycle resulted in a profit

We are habituated to buy at the lower P/E and sell at the higher P/E but the same is not applicable in the cyclical industry. We have to buy company during the bad cycle which has depressed earnings that shows higher P/E and need to sell during the good cycle which has good earning that has depressed P/E. So, if we buy at the lower P/E then we end up with losses though P/E will be increased. Also, higher-earning is temporary and as the cycle turns out then earnings will disappear.

We can start reading an annual report from the backside so that some facts which the company wants to hide in the last section which comes first to us. Always read footnotes, focus more on learning about financial reporting.

Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation. 

Read for more detail: The Intelligent Investor by Benjamin Graham, Jason Zweig