Question

High-quality earnings metrics are said to have confirmatory and predictive value. What does this mean? Discuss in the context of proforma earnings?

Answer 1

One number that analysts like to track is net income. It provides a point of reference for how well the company is doing from an earnings perspective. If net income is higher than it was the previous quarter or year, and if it beats analyst estimates, it's a win for the company.

But how reliable are these earnings numbers? Due to the myriad of accounting conventions, companies can manipulate earnings numbers up or down to serve their own needs.

Some companies manipulate earnings downward to reduce the taxes they owe. Others find ways to artificially inflate earnings to make them look better to analysts and investors.

Companies that manipulate their earnings are said to have poor or low earnings quality. Companies that do not manipulate their earnings have a high quality of earnings.

As noted above, companies with a high quality of earnings stick with the GAAP standards. The fundamental qualities of those standards are reliability and relevance. That is:

• Reliability: The metric is verifiable, free from error or bias, and accurately represents the transaction.
• Relevance: The metric is timely and has predictive power. It can confirm or contradict prior predictions and has value when making new predictions.