Richard Sloan: Dodging "Earnings Torpedoes"
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Selecting companies with good earnings quality enables investors to avoid getting stung, says Business Professor Richard Sloan.
Today's stock investors seem to be fixated on company earnings as indicators of value and pricing. However, they may be focusing on the wrong thing, according to Richard G. Sloan, the Victor L. Bernard-PricewaterhouseCoopers Collegiate Professor of Accounting at the University of Michigan Business School.
When corporate revenues begin to slip in the wake of an economic slowdown, companies are tempted to use the accounting sleight of hand to keep earnings growth on track. They may report current earnings based on the assumption they will get large cash flows in the future. Often these "guesstimates" are overly optimistic.
"Some firms look like they have great earnings, and on that they get great stock prices," says Sloan. "Then suddenly, it is revealed the anticipated cash flows are not going to be collected, and their stock prices drop precipitously." He calls these large drops in stock price, which are triggered by disappointing news about the earnings performance of companies, "earnings torpedoes."
Over the past year, investors have seen all to many "earnings torpedoes." Lucent, Gateway, Palm, Cendant and Sunbeam are just a few of the high flyers with once-rosy earnings reports that have crashed and burned, taking millions of hard-earned investment dollars down with them.
Sloan contends it is crucial for stock investors to look for companies with good earnings quality rather than just good earnings. By definition, companies with good earnings quality have both high earnings and high cash flow and the ability to sustain that cash flow at current levels into the future.
"Some investors use earnings as an indication of company value," says Sloan. "I demonstrate that if you do a detailed evaluation of the underlying cash flow supporting earnings, you can learn more about what the company is really worth." Simply put, firms that have high earnings but not high cash flows are more likely to disappoint in their future earnings.
Sloan designed a "quality of earnings" formula in 1990 while teaching accounting at the University of Pennsylvania's Wharton School and back-tested it on thousands of companies over a span of 40 years. "I found the formula worked very well in terms of predicting which companies would have earnings disappointments in the future," he says.
In the next stage of his research, Sloan looked at the stock market reaction during that time period to see if these "earnings torpedoes" took the investment community by surprise. Then, using his quality-of earnings formula, he developed a trading strategy based upon the ability to identify companies that are likely to disappoint on their earnings.
Sloan admits his research was considered pretty controversial when he first published it in 1996. Over the ensuing years, however, it gradually has gained widespread acceptance. Since joining Michigan's Business School faculty in 1997, Sloan has refined and popularized his earnings-quality analysis. This summer he received the American Accounting Association's annual award for "notable contributions to the accounting literature" for his work in this area.
Recently, Sloan has become a familiar face on Wall Street and the national conference circuit. On campus, he has incorporated his quality-of earnings screening into two of his Business School courses, one on financial statement analysis and the other on portfolio management. He also has developed a new software product, eVal, designed to help students build a more comprehensive valuation model for any publicly traded U.S. company using a series of sophisticated spreadsheets. "As it has turned out, every man and his dog are doing this now," says Sloan. "From students to practitioners and academics, there is now a lot of interest in this area."
Just over 18 months ago, Sloan spearheaded the creation of a financial research and trading facility, commonly called the Trading Floor, on the Kresge Library's fourth floor. A grant from Dell Computer and online access to financial tools from major brokerage houses helped to equip this state-of-the-art facility with 11 computers and proprietary software, which enable students and faculty to analyze, track and trade stocks in real time.
"The purpose of the Trading Floor is to get students over that hump of being in a traditional classroom setting to where they are solving real-world problems using highly sophisticated software that was created to apply the classroom theory," says Sloan. Students in his Applied Financial Analysis and Portfolio Management classes trade stocks in a real portfolio of $100,000, provided by the School for educational purposes, utilizing earnings-quality analysis to identify stocks with good earnings quality. "We're up 15 percent, while our benchmarks are down 10 to 40 percent," reports Sloan.
In addition to classroom activities, Business School students maintain two Web sites, www.earningstorpedo.com, which lists companies they think will have earnings disappointments based upon their earnings-quality analysis, and www.valuedog.com, which identifies under-priced stocks with strong underlying cash flows.
"Now we are in an environment where everyone is realizing fundamentals are important and valuation ultimately must be tied to those fundamentals," says Sloan. "We are seeing that quality-of-earnings analysis is really critical, especially with high-tech companies."
Looking toward the future, he predicts it is unlikely the stock market will return to the euphoria of 1999 and early 2000 when Internet companies were inflated by stratospheric stock prices, and venture capitalists were plowing big bucks into start-up companies with no revenue or earnings.
"Now that investors are a lot more skeptical and more hesitant to throw money at the customers of technology companies, these firms are going to have a much rougher time growing their sales and earnings," says Sloan. "Eventually these companies will work through their inventories, but then sales and earnings growth will be a lot slower."
To contact Sloan, e-mail sloanr@umich.edu. Visit www.earningstorpedo.com and www.valuedog.com.