Investing Book Review: Quality of Earnings

October 13, 2009 | Comments (15)

Investing Book Review of Quality of Earnings

Quality of Earnings

Quality of Earnings

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.

List Price: $16.95
Current Price: $11.54
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About Jae Jun


Jae Jun is the founder of Old School Value. He is on a mission to provide practical and actionable value investing tools, tutorials and educational material to help empower the individual investor. Keep in touch with Jae via any of the methods linked below.

  • Floris

    I ordered it 2 weeks ago from amazon.com. Here hoping the boat will hurry up and deliver my books to the other side of the pond.

  • X

    Jae,

    I wonder if this book is similar to “Financial Shenangians”? … which focuses on how companies try to inflate their earnings and utilize accounting metrics to distort their net income and cash flow statement.

    It includes a list of things to look for that may cause for red flags.

    Also, what did this author say about dividends matter? And, on a tangent, how have you accounted for dividends in your models? Do you use the DDM approach from time to time?


    X

  • http://www.oldschoolvalue.com Jae Jun

    I haven’t read the Shenanigans but it’s probably similar.

    The author doesn’t like dividends. He says that companies that pay dividends are too set on either increasing or maintaining even when the company is clearly in trouble.

    Rather than admit that they are in trouble and need to use the excess cash back in its operations they raise it or still try to pay it. BAC last year is a prime example.

    Another way management use dividends it to maintain their stock price so that when it comes time for them to require financing, they can get a better deal.

    I personally have never really focused on dividends. If a company pays it, that’s ok, but whether they do or don’t, it doesn’t affect my decision.

    I’m thinking of adding a DDM to the spreadsheet. Never used it before as it doesn’t apply to what I look for but many other users may like it.

    What’s your experience with the DDM?
    Any advantages, disadvantages?

  • http://valueinvestortoday.com Jim

    Just ordered the book and look forward to the read. Thanks for the recommendation Jae.
    .-= Jim´s last blog ..The Wall Of Shame =-.

  • http://www.oldschoolvalue.com Jae Jun

    No worries Jim. Always willing to share the good stuff. Also heard from people that actually know the author what a fine and generous person he is. Makes it more enjoyable to read.

  • http://valueinvestortoday.com Jim

    Jae, according to wiki, Robert Sobel has some interesting facts which include being a chess master and beating Bobby Fischer in a chess game once. He apparently died in 1999. I’ve nearly completed my first read of his book and I must say it is one of the best I’ve read.
    .-= Jim´s last blog ..Equity Risk =-.

  • http://www.oldschoolvalue.com Jae Jun

    Sorry but who is Robert Sobel? Not sure which book you are referring to.

  • http://valueinvestortoday.com Jim

    Jae,

    Robert Sobel helped Thornton O’Glove write the book ‘Quality of Earnings’.
    .-= Jim´s last blog ..Did Value Investor Mark Sellers Over-Value PRXI? =-.

  • Tylergold

    Hi Jae, Tyler Here,

    i got lucky my parents bought me 4 books
    - the intelligent investor
    - security analysis 6th edition
    - Valuation Techniques
    - Reading Financial statements

    im reading the intelligent investor 1st what should i read next thanks.

    what valuation techniques do u use?

  • http://www.oldschoolvalue.com Jae Jun

    Tyler,

    Good list of books.
    Personally, I would read the intelligent investor last. Security analysis is more like a textbook than a book so I don’t think you will have to read every single page.

    Reading financial statements should always be at the top of the list.

  • Carl

    If you have read Quality of Earnings, you might want to check out Creative Cash Flow Reporting.

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