Thursday, March 30, 2006

Quality of Earnings by Thornton O'glove :: Book review

Quality of Earnings is an essential book for everyone who likes value investing. First published in 1987, Quality of Earnings provides a good introduction to understanding the idea of quality of earnings. Thornton O'glove teaches you how to accurately gauge weather earnings have been created by good management or created by good accounting.

O'Glove covers common sources of low quality earnings with worked examples from 1980s.

  1. Non Operating and Non recurring Income

  2. Extraordinary increases and decreases in expenses
  3. Growth in inventory and accounts receivables that is not backed by sales
  4. Issues with recognition of debt and cashflow
  5. Changes in accounting methods and assumptions
  6. Restructuring charges

Certain aspects of this book are dated to the 1980s when it was written. The threat of hostile takeovers is constantly emphasized. Today hostile takeovers are quite rare, because of recognition that the hostile acquiring company usually ends up overpaying, and the merged companies tend to lag their undisturbed competitors.

Because the format for the statement of cash flows, was only standardized in 1988: O'glove spends only very small amount of time on the important subject of reconciling cash flows with income. Today the reconciliation of EBITDA to Net Income and reconciling Operating Cash Flow to Net Income are essential methods for evaluating earnings quality.

His chapters on quality of inventory and quality of sales are excellent. This book does not assume an accounting background. Readers without any accounting background may want to read Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reportsion by Howard M. Schilit first. "Financial Shenanigans" is a gentle introduction to world of deceptive accounting.

I highly recommend Quality of Earnings for all investors who pick individual stocks. Recognizing a company whose high quality earnings are not being appreciated by the markets is the core of my style of value investing. A reviewer on said it best "The issue of transparency in the markets is critical to assessing value. This book is an excellent introduction to the topic."