Determining the quality of earnings of a company

MANY investors find it difficult to judge the earnings quality of a company. Sometimes, some investors may misread the cheapness of a company when they see that the company’s price-to-earnings ratio (PER) is low.

However, a low PER does not necessarily mean that the company is undervalued if the earnings increase is not from a genuine increase in profit due to sustainable sources, such as higher revenue or lower operating costs.

A certain portion of profits may not be derived from the normal business operations, instead, the gains may be generated from the disposal of assets, which is a one-time event.

Hence, one of the available tools to judge the quality of earnings of a company is to divide the operating cashflow generated by the company over its outstanding shares.

Some analysts name it as cash per share, some may label it as operating cashflow per share or cash earnings per share (cash EPS). In this article, we name it as cash EPS.

Cash EPS measures the net operating cashflow of a company on a per share basis. Higher cash EPS implies that the business is getting more cash inflows than cash outflows from its operating activities.

Even though getting more cash inflows do not necessarily mean that the business is definitely making a lot of profits, but logically, if a company is consistently getting excess operating cashflow, the business is surely generating extra cash from its sales after deducting all required payments related to the sales.

The excess cash from operation can be utilised to purchase new fixed assets (for example plant, equipment and land) or to reward shareholders in the form of dividends or to reduce bank borrowings.

Cash EPS by itself does not contribute much information to us.

However, it is quite powerful if we divide the stock price over its cash EPS and compare it with its current PER.

Let us look at the table above.

Assuming Stock A and Stock B have the same stock price of RM1, earnings per share (EPS) of 10 sen and a PER of 10 times.

Even though both of them have the same PER of 10 times, given that Stock A has cash EPS of 20 sen whereas Stock B has cash EPS of 5 sen, price/cash EPS for Stock A and B are computed at five times and 20 times respectively.

In view of Stock A’s price/cash EPS of five times is lower than Stock B’s 20 times, Stock A’s EPS of 10 sen will be considered as a higher quality EPS compare with Stock B’s EPS of 10 sen.

This is because Stock A may be more efficient in its debt collection or inventory management while its lower net income may be due to some exceptional losses which affect its net income but not its operating cashflow.

In the case of Stock B, with its EPS of 10 sen higher than its cash EPS of 5 sen, the high net income may be due to gains generated from exceptional items, such as the disposal of assets, or the company may have problems in its debt collections.

The high profit from Stock B does not translate into the actual cashflow.

If its operating cashflow continues to be low and turn negative in the later periods, Stock B may require extra financing either from its shareholders or banks.

If this situation persists for a long period, at some point in time, the shareholders or bankers may stop financing and want to be repaid.

In short, high earnings do not necessarily mean high cashflow to the company.

Given that it is much harder to manipulate the cashflow statement, cash EPS gives us the net effect of the inflow and outflow of money from its day-to-day operation.

A good and growing company will normally display a growing trend of higher cash EPS against its EPS.

● Ooi Kok Hwa is an investment adviser and managing partner of MRR Consulting.

Thestar