Part 12:  The Deceptive Nature of Short-Term Earnings

Words: 512 Time: 3 Minutes

💥 Why This Matters

• Don’t Be Fooled by Short-Term Earnings: Investors should be wary of overemphasizing a single year’s earnings, as they can be influenced by various accounting treatments and may not reflect a company’s true long-term earning power

• Beware of Accounting Gimmicks: Companies can manipulate earnings through special charges, tax credits, depreciation methods, and other accounting choices. Investors need to be critical and look beyond the headline numbers to understand the true profitability of a company

• Focus on Long-Term Trends: Analyze average earnings over a longer period, consider the company’s growth rate and its sustainability, and evaluate its performance relative to industry conditions and long-term trends, rather than fixating on short-term fluctuations

📝  Introduction

While long-term performance is the ultimate measure of a company’s success, investors often get caught up in the allure of short-term earnings.

This chapter highlights the potential pitfalls of focusing too heavily on quarterly or annual earnings figures and emphasizes the importance of a long-term perspective (for example, average the earnings over a 3-year and 10-year horizon).

🪄 The Illusion of Precision

Earnings per share (EPS) figures, often presented with an air of precision, can be misleading due to various accounting treatments.

For example, special charges, dilution, tax credits, and depreciation methods can all significantly impact reported earnings, making it difficult to compare figures across different periods or companies.

Investors should be wary of taking these numbers at face value and delve deeper into the footnotes and accounting policies to understand the true picture of a company’s profitability.

🔮 The Manipulation of Earnings

Companies may use accounting techniques to manipulate earnings and present a more favorable picture than reality. This can include:

1. Strategic Timing of Charges: Taking large special charges in a single period to “clean up” the balance sheet and boost future earnings.

2. Capitalization of Expenses: Companies can misuse capitalization to inflate profits by treating operating expenses as assets. This can artificially boost reported earnings and mask underlying weaknesses in the business. Investors should carefully analyze a company’s capitalization policies and understand the rationale behind them to ensure they are not being used to manipulate earnings.

3. Creative Accounting: Exploiting accounting rules to inflate earnings or hide losses, making it difficult to assess true performance

4. Aggressive Revenue Recognition: Companies may manipulate revenue recognition practices to prematurely book sales and inflate reported earnings. This can involve recognizing revenue before cash is collected, inappropriately capitalizing expenses, or mischaracterizing transactions.

5. Misusing Tax Credits:  Using tax credits from past losses to offset current taxes, creating an artificially high profit margin

 Key Takeaways

• The allure of executive remuneration based on stock options and the pressure to meet Wall Street’s expectations have incentivized some companies to manipulate earnings.

• It’s crucial to recognize and avoid these potential “numbers games” that can often distort a company’s true financial picture.

• Warren Buffett reminds us, to get a more reliable measure of a company’s true health – look at its free cash flow (over a long period) rather than its earnings.