From Warren Buffett's 1990 Berkshire Hathaway (BRKa) shareholder letter:
"The term 'earnings' has a precise ring to it. And when an earnings figure is accompanied by an unqualified auditor's certificate, a naive reader might think it comparable in certitude to pi, calculated to dozens of decimal places.
In reality, however, earnings can be as pliable as putty when a charlatan heads the company reporting them. Eventually truth will surface, but in the meantime a lot of money can change hands. Indeed, some important American fortunes have been created by the monetization of accounting mirages."
It's pretty tough to identify where the bad accounting behavior is going to show up (events at certain companies in recent years have clearly demonstrated that).
Yet there are actually often more than a few red flags. At least enough of them to just decide to avoid something even if you can't figure out precisely what the heck is going on.
"The stock market is a no-called-strike game. You don't have to swing at everything--you can wait for your pitch." - Warren Buffett
The best defense is buying businesses run by managers with a strong reputation and track record of fostering a conservative accounting culture (again, not easy to identify or find).
In fact, all things being equal (they never are, of course) I wouldn't hesitate to buy a slightly inferior business if I thought the management was being conservative and that accounting chicanery had a lower probability of happening.
The problem is that earnings are not particularly precise even when management is doing its best to report the numbers honestly. Accounting has its inherent limitations.
That is one of many reasons why I find the obsession with quarterly results kind of humorous. Reported earnings are just not as meaningful on a quarterly basis as some would suggest (though reading quarterly earnings reports can be a very productive way to begin getting familiar with a company). Now, string ten or twenty quarterly earnings reports together and then you can begin to understand how a business performs in many different business environments.
For cyclical businesses, I'm more comfortable taking the average earnings and free cash flow over a full business cycle. I then decide what it's worth and what kind of margin of safety I want based upon that. If free cash flow is consistently lower than earnings over that time frame I avoid it. Occasionally free cash flow will consistently exceed earnings as a result of something like depreciation or amortization (or other non-cash expenses) being in excess of capex. Mohawk (MHK) is a cyclical business that has been an example of this in recent years.
That's an attractive situation only if management is not starving the business of the key investments that are necessary for it to remain competitive over the long haul.
For non-cyclical businesses like Pepsi (PEP) or Coca-Cola (KO), I'm much more comfortable using current year earnings and free cash flow. That's only the case because there are enough years (well, decades in fact) of evidence to suggest that the earnings power at those two businesses is extremely resilient.
Long all stocks mentioned
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