Behind the Numbers: When It Comes to Earnings, Look for Quality, Not Just Quantity

As we head into earnings season for the secondquarter, make sure that you're focusing on what matters most. All too often investors fixate on how much a company is earning, rather than the actual quality of the earnings. Yet with so many companies missing estimates these days, the practice of measuring earnings quality can help you identify which companies are best positioned to make their projections.

Experts say that savvy investors look at a few additional performance measures, and doing so doesn't require a Ph.D. in quantitative analysis. Most of the telltale signs can be calculated by looking at the income statement, balance sheet, or annual report footnotes: items such as free cash flow, revenue growth, inventories, receivables, and research and development.

Examining variables like these will help you find companies with the best chances of repeating their earnings growth, says Maceo K. Sloan, chief investment officer of NCM Capital in Durham, North Carolina (No. 6 on the BE ASSET MANAGERS list with $2.9 billion in assets under management). "You are looking for companies you can depend on to do better than, or at least meet expectations quarter after quarter," Sloan says. "These are companies where earnings are coming from the operations, not from extraordinary events that may happen and are not necessarily going to be repeated."

Companies that make earnings targets by benefiting from a lower tax rate, or booking orders not yet fulfilled could mean trouble. Investors should always ask: "Are the earnings an honest assessment of the true economic picture of the company, or is it just smoke and mirrors?" says Dirk van Dijk, director of research at Zacks Investment Research Inc. in Chicago.

The ability to find quality earnings comes in handy during today's uncertain times: Many sectors of the market have been hit hard in recent months, and it's difficult to get a handle on where things are headed. Though the S&P 500 index fell nearly 10% in the first quarter, by mid-May it was down just 3% for the yeas It's in a tough economic environment that executives might be inclined to look for ways to make earnings better than they really are--legally, of course.

"What we have seen in downturns is companies will try to keep their earnings up and will use any devices they can," says Victor Germack president of Rate Financials, a New York-based firm that rates corporate earnings quality. "There is that temptation."