Certain companies are
Earnings can be decomposed into two parts: Cash Flow and Accruals. The accrual accounting doctrine requires companies to record revenues and expenses when they are earned and incurred, which is not necessarily when cash is received or paid; the difference between cash earnings and reported earnings are termed "accruals." Accruals, unlike cash flow, are subject to estimation errors and judgment.
We measure accruals as changes in operating assets and liabilities from four quarters ago to the most recent quarter. We measure changes in both current and non-current operating assets and liabilities. Accruals are scaled by average assets.
The second half of earnings is cash flow. Like accruals, operating cash flow is a component of earnings. Operating cash flow is defined as the net of cash flow from operations and cash flow from investment. Unlike accruals, cash flow is relatively free of estimation error and therefore is more reliable than accruals.
We measure cash flow as the annualized (T4Q) free cash flow
. Cash flow is scaled by average assets.
Return on Assets (ROA) is the primary measure of operating efficiency. ROA reflects the internal rate of return on company projects. Our research indicates that on average, 70% of current-year ROA persists into the next year.
To identify the sources of differences in ROA persistence, we can decompose ROA into a profit margin sub-component and an asset turnover sub-component similar to a DuPont analysis.
| ROA =
The profit margin sub-component indicates the company's effectiveness in controlling the cost of sales. The turnover ratio sub-component indicates the level of sales which can be generated from a given asset base. The third and final sub-component measures changes in asset turnover.
We evaluate asset turnover and profit margin against sector benchmarks because of the structurally different ways in which companies in various industries produce similar levels of ROA. For example, a shipbuilder exhibits high margins but low turnover, whereas a supermarket exhibits low margins but high turnover, but the two companies might have the same ROA.
Profit margin is measured using the annualized (T4Q) operating profit margin as a percentage of annualized sales. Asset turnover is calculated using the annualized sales to average net operating assets. Change in asset turnover measures the annualized asset turnover for the most recent quarter minus the annualized asset turnover from four quarters ago.
Exclusions (North America Only)
The final concept used by the StarMine Earnings Quality model is a measure of the degree to which reported earnings reflect operating earnings. Companies commonly define their own "pro forma", or reported, earnings measure and report this measure in their quarterly press releases. Companies defend the use of pro forma earnings by suggesting that the items included in GAAP earnings, but excluded from pro forma, are typically not core operating earnings and therefore do not reflect the company's ongoing earnings potential. As such, pro forma earnings are typically close to operating earnings before interest and taxes, but after depreciation and amortization. However, the practice is sometimes abused, and pro forma earnings can allow companies to present to the public "earnings before the bad stuff." Companies may also adjust the basis used in pro forma earnings in order to beat a benchmark such as analysts' expectations, prior reported earnings, or zero earnings.
We can attribute the difference between pro forma earnings and operating earnings to "special items" and "other exclusions." Both of these sources - special items and other exclusions - have a negative impact on future earnings growth.
The Exclusions component of the model breaks exclusions into two sub-components:
- Special Items
- Other Exclusions
We measure the two Exclusions sub-components using the most recent quarterly value scaled by average assets.