Investing Book Review: Quality of Earnings

Quality of Earnings: The Investor’s Guide to How Much Money A Company Is Really Making

If you’re into value investing, which of the three financial statements do you concentrate on the most?

I tend to perform balance sheet analysis and cash flow statement analysis much deeper than the income statement. I would guess that you do the same.

That’s where this gem of a book Quality of Earnings comes in. Thorton L.O’Glove has written an absolutely brilliant investment book for the DIY investor.

The fact that hardly anyone has ever heard of this book cements the fact that you will have an edge after reading this book.

For the Enterprising Value Investor

I first came across this investing book while reading The Art of Short Selling, and if a highly acclaimed fundamental short seller highly recommends a book on financial statement analysis, I’m all over it.

First of all, the book is perfect if you are willing to read, go through reports, write some numbers and do some simple math.

If this sounds like too much work… at least the advice is timeless.

Quality of Earnings

As the title of the book suggests, the main focus is on earnings and the quality behind it.

The first 5 chapters deals with the reason why you shouldn’t trust analysts, auditors, letter to shareholders and disclosures in the annual report.

It’s not just a simple discussion though, consistent with the entire book, the author provides examples galore. He even goes through a letter to shareholders and compares what the CEO said to the actual results.

Now that’s what I call holding your hand and walking you through the details!

Financial Statement Analysis Techniques

Earnings are highly manipulative, especially because the GAAP rules are so broad. This undeniably leads many companies to overstate their earnings through aggressive accounting methods.

Wall Street only focuses on the final EPS that is quoted in the press release and at the bottom of the income statement, but O’Glove leads you through methods on what to look for and the simple math you should perform in order to compare with the previous years.

Ever asked yourself the following questions?

• What should you do with non-operating and non-recurring income?
• How do you analyze the status of a company based on declining or increasing expenses?
• What is the difference between shareholder reporting and tax reporting?
• How do you analyze accounts receivables and inventory?
• How should you analyze debt and cash flow?
• Do dividends matter?
• How do different accounting methods affect the value of a company?

The book will help answer all of the above questions.

Why this is Relevant and Important

The obvious time you ask all the questions about a company is before you purchase it. But the lessons in the book help you to identify the flaws before it comes out in public. This could mean saving yourself a lot of money by selling a deteriorating position.

e.g. by examining the difference in growth between raw materials, finished goods and accounts receivables, you will have a good indication that a company will write down its inventory.

Summary

Quality of Earnings is a great book if you want to deepen your understanding of analyzing companies and valuation.

The book may be old but the techniques and advice contained within is timeless.