How Will Earnings Quality Issues Impact The Company’s Share Price?

Given that Gradient Analytics’ research is primarily focused on forensic accounting, this common client question falls into our sweet spot. However, the link between earnings quality concerns and share price underperformance can be difficult to assess for two reasons:

Investors and sell-side analysts tend to focus their attention on the income statement, but there is not always a predictable correlation between the highlighted balance sheet trends and the income statement impact.

Because management has a huge amount of discretion over how accounting entries are handled (including when to recognize built-up expenses, impairments, non-cash gains, etc.), earnings quality concerns often have ambiguous timing.

Thus, investors often are left wondering just how and when eroding earnings quality in their portfolio holdings – whether long or short – will ultimately impact their fund’s performance.

Nevertheless, to illustrate how such red flags may indeed lead to notable share price decline, I will describe three real-life examples. For compliance reasons, I won’t disclose their names, but will simply refer to them as Company A, B, and C. Read on….

The Retailer:

For Company A, we had concerns that the firm’s transition from a brick-and-mortar retailer to an “omni-channel” retailer would soon begin to weigh on its gross margins. In fact, its expansion into this new online sales channel would soon bring it into direct competition with Amazon. In addition to the fundamental challenges, the firm’s inventory metrics were trending in the wrong direction. For example, elevated inventory levels were expected to weigh heavily on future margins such that markdowns (or impairments) would be required to ultimately sell the merchandise. Moreover, this buildup of inventory was a negative signal in and of itself. Because management had clearly overestimated demand in recent months, we felt that there was an increased chance that future sales also would be disappointing.