Wednesday, April 1, 2009

Reporting Positive EPS in Decline? Unusual Strength in a Time of Weakness

Many people are looking for the end of the recession, but are starting to "read into the signs" a little too much (or perhaps not enough). Some of the major US banks reported positive earnings (such as Citigroup), but analysts should be particularly careful in times like these before starting to get back into the market.

But positive earnings in a recession should be good news right? Not really. Do the math and look at the underlying story. How strong are your "earnings"? There are many common (legal) ways to inflate your EPS (which most diligent analysts will be trained to observe):
  • Sale of assets / subsidiaries / securities (realization of a gain)
  • LIFO reserve liquidation (sale of inventory that is not replaced)*
  • Redeeming a tax deferred asset / tax deferring strategies
  • Asset re-evaluations (highly restrictive and a generally noisy way to fix a delicate problem)
These strategies are generally analogous to having a garage sale or going to the pawn shop in order to pay the bills and eat. Yes, you have money coming in, but this only works for a while. Eventually, you run out of stuff to sell and you need to start making money some other way.

* Note that due to GAAP, LIFO can only be used in American companies (30% of which use this accounting method) whereas IFRS doers not permit this practice (FIFO and WAC methods only)

This list excludes illegal methods, of course, such as World Com's incorrect capitalizing of an expense. World Com wrongly capitalized in line costs that should have been expensed (and were until 2002). This resulted in an investment cashflow out rather than the proper expense reducing cash flow from operations (it's not an investment outflow expected to bring in returns as much as it is an operating expense, similar to COGS).

In times like these, it becomes even more important to use your financial ratios when evaluating the fundamentals and determine how much harder you have to work to get an extra dollar of revenue (using your operating cash flow ratios).

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