The Importance of Quality Earnings

Forbes has a nice piece about looking beyond earnings to see whether or not they are hiding potential problems.

Krispy kreme doughnuts is the latest illustration of the fact that stunning earnings growth can mask a lot of trouble. Not long ago the doughnutmaker was a glamour stock with a 60% earnings-per-share growth rate and a multiple to match-70 times trailing earnings. Now the stock is at $9.61, down 72% from May, when the company first issued an earnings warning. Turns out Krispy Kreme may have leavened profits in the way it accounted for the purchase of franchised stores and by failing to book adequate reserves for doubtful accounts. So claims a shareholder lawsuit against the company. Krispy Kreme would not comment on the suit.

Investors are not auditors, they don't have subpoena power, and they can't know about such disasters in advance. But sometimes they can get hints that the quality of a company's earnings is a little shaky. In Krispy's case an indication that it was straining to deliver its growth story came three years ago in its use of synthetic leases to finance expansion. Forbes described these leases in a Feb. 18, 2002 story that did not please the company. Another straw in the wind: weak free cash flow from operations. You get that number by taking the "cash flow from operations" reported on the "consolidated statement of cash flows," then subtracting capital expenditures. Solid earners usually throw off lots of positive free cash flow. At Krispy the figure was negative.

If you are interested in this stuff, also see stock returns and fuzzy accounting.