Wall Street is a harsh judge when it comes to missing earnings estimates. It is not uncommon for a stock to significantly report quarterly earnings are below the consensus estimate. This is especially true for aggressive growth stocks, because there is often a high degree of optimism embedded into the price and therefore less room for error.
Thus, the incentive for management to meet or beat estimates is enormous. This can lead to earnings manipulation by companies that fall short of the intended goal. Even though it may seem like a questionable practice, there are some legal accounting adjustments that can be made to earnings to make them look better that many companies engage in. A few accounting tweaks late in a quarter can help to achieve a desired result. Although these "tweaks" might be legal, earnings manipulation can come back to haunt a company if it is not truly growing.
Two common ways a company can manage earnings are:
Pension Plans - Companies that have Defined Benefit Plans have to report their pension expense which goes against earnings. This number can be artificially reduced by deliberately assuming a low rate of expected compensation growth or are a higher expected return on plan assets. Both of these will lower the reported pension expense and increase net income. At some point, however, the company will need to readjust the figures to meet its true pension obligations.
Depreciation Method - Depreciation is the process by which a company allocates an asset's cost over the duration of its useful life. A firm can tinker with the method of depreciation and overestimate the salvage value of the asset, both of which would increase reported earnings. If a corporate executive wants to be very aggressive he can set aside a "reserve" fund from good years to use in bad years. The idea is to smooth out earnings as Wall Street likes consistency rather than wild swings in results. Smoothing earnings is not permitted by the SEC, and it ends badly for shareholders when the jar runs dry.
Fortunately, there are ways for an investor to ensure a company is truly growing as opposed to simply doing a good job of managing the numbers. One thing to look at is sales growth. No firm can consistently grow earnings without also growing sales. Aggressive growth stocks should be growing sales at a comparable rate to earnings, otherwise trouble is inevitable down the road. A more mature company has more capacity to wring out earnings growth by cutting costs, but not a younger firm. (Keep in mind that sales can be manipulated, but doing so is harder and is more likely to be uncovered by an audit, because of their affect on receivables and inventory.)
Cash flows are another place to gauge a company’s health, especially operating cash flows. These are the cash flows from the firm’s main operations, and growth in this metric is crucial in order for continued success. Operating cash flow measures whether a company is actually increasing its cash balance through its normal activities or if it is using more cash than it is getting from its customers. There are many stories of aggressive growth companies that filed for bankruptcy because they could not generate cash to pay the bills. Cash flows are very difficult to manipulate without violating common accounting standards.
Conclusion
Earnings are an extremely important metric to keep an eye on, but are rife with opportunities for manipulation by sneaky management teams. Continue to keep an eye on earnings and earnings estimate trends, but also beware various tricks that firms can play to spice up their reported results. As an alternative, study the company’s sales growth and cash flow growth, especially cash flow from operations.
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