Dollar$ and Sense: Be Aware of Earnings Inflation Tricks

BY CHRIS HANLY
INVESTMENT CONSULTANT, GARY GOLDBERG FINANCIAL SERVICES

Corporate earnings for the first quarter of the year were once again sub-par, declining some 6% year over year. Of course, there were some bright spots, with some companies handily beating expectations, and in some cases even doing so legitimately…

Investors have been conditioned to focus on earnings, looking for companies whose earnings grow by a meaningful amount each quarter and each year. And while earnings growth is paramount, it is important to understand that not all earnings growth is comparable, and therefore the analysis requires further scrutiny. Earnings or earnings per share are essentially total revenues, less costs, divided by the number of shares outstanding. For example: Company “A” has $1 billion in revenues and a 25% profit margin – hence the business has $250 million in “earnings.” If the company has 10 million shares outstanding, the Earnings per Share (EPS) is $2.50. A company that is targeting a 10% annual growth rate should therefore have EPS of $2.75 in the following year. All things being equal, the firm should have $1.1 billion in revenues, maintain that 25% profit margin to end up with the $2.75 EPS number. But what if revenues didn’t grow, and in fact fell to $900 million in the subsequent year. This is where financial engineering comes into play, and with it potential risks to investors. The company could do several things to still reach that targeted 10% EPS growth – 1) It could reduce costs, mostly headcount as the accounting is most beneficial, raising margins to over 30%. While cost cuts sound like a good thing, in this instance it would likely have a negative impact on future growth – not something investors want to see. 2) The company could buy-back shares – by reducing the shares outstanding by about 1.8 million shares, the company will have achieved the EPS growth rate even though earnings themselves haven’t grown a penny (as a matter of fact they fell).

As an alternative to simply focusing on earnings and earnings per share, investors should keep a keen eye on revenues. There is very little clever accounting or other manipulative practices corporate chieftains can do to impact revenues – because the “top line” as it’s often called, is a very straight forward number. The GGFS Revenue Buster Program focuses on just that – revenue and revenue growth. The portfolio invests in 19 to 21 companies that demonstrated strong revenue growth and, most importantly, are expected to continue to grow at a solid pace. Most of the companies in the portfolio share the following characteristics: They are taking market share away from competitors, are innovative and often the leaders in their field, and have rock-solid balance sheets. Focusing on revenue growth and solid balance sheets is particularly important in our current slow-growth environment. And while the companies found in the Revenue Buster program could, individually, demonstrate some higher volatility, the portfolio as a whole is constructed to help manage this risk. Of course, investors can do some of this work themselves, analyzing industry growth cycles, company specific balance sheets, as well as cyclical factors that can impact the business cycle. If you’d like to learn more about how GGFS approaches portfolio construction and how we might be able to help, give me a call.

Christopher Hanly is an investment consultant with Gary Goldberg Financial Services in Suffern and can be reached at 845-368-2907 or [email protected].