What is Quality of Earnings?
Quality of earnings describes the amount of profit from core operations rather than accounting methods, extraordinary situations or earnings management.
How Does Quality of Earnings Work?
For example, let's say that Company XYZ's sales increase by 200%, its general and administrative expenses decrease by 10% and its net income increases by 140%.
Now let's say that Company ABC's sales stay flat, its expenses rise only slightly and its net income increases by 140% because it changed the way it depreciated some of its assets and inventory.
Most analysts will say that Company XYZ has better earnings quality than Company ABC because Company XYZ's earnings are from genuine improvements in core operations -- the sale of products. Company ABC's net income rose by just as much, but because it was the result of accounting changes, the earnings increases are little more than paper profits. Company ABC hasn't done anything illegal or wrong, but its quality of earnings is lower than Company XYZ's.
Why Does Quality of Earnings Matter?
Stock prices rise and fall on earnings, and so in order to determine whether a stock price increase is here to stay, many analysts and investors look to earnings quality. A company that is genuinely doing well will show increases in sales and steady changes in expenses rather than rely on accounting changes to artificially pump things up. Regardless, the temptation to rely on accounting methods to improve earnings is widespread and is especially strong for companies that have cyclical sales and profits.