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Quality of Earnings
An indispensable guide to determining how much money a company is really making and for buying and selling stocks without making costly blunders.
224 pages, Paperback
First published April 27, 1987
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January 29, 2021
This book is an interesting relic from 1987, and has a lot of useful concepts and tips. The main idea of this book is to do your own homework, read the primary documents, and look carefully at the financial statements. Focusing on a single number like EPS is likely to obscure many things going on under the surface. All of these principles are useful for any investor. However, the book suffers from a few problems: 1) It's a fairly dry read and much of the book involves writing out calculations. 2) The book is too advanced for the novice and too surface-level for the practitioner. Many of the issues in the book have been rectified by standardized reporting of the cash flow statement, and investor focus on operating earnings/free cash flow. Notably, this is likely because Thorton L. O'glove's ideas have been very influential. But the adjusted earnings that many companies report today suffer from the opposite problem: companies try to paint a picture of what "normalized adjusted earnings" are when there really is no such thing for businesses who will inevitably face hiccups from time to time. 3) To the extent that some of the concepts are helpful, they're diminished by the author's focus on short-term year-over-year comparisons vs. "Street expectations." The book would benefit from some overall contextualization of the goal: to find how much free cash the business can actually generate.
A few of the key concepts in the book:
1. Don't trust Wall Street analysts, and don't trust your auditor. Both have conflicting incentives (street analysts want to be liked by management, auditors get paid by the Company who they audit who also presents cross-selling business opportunities). Ultimately you have to look at and interpret financial statements for yourself.
2. It can be useful to compare the management tone in annual shareholder letters against what the 10-K SEC disclosures actually say. If management is excessively positive while the financials and SEC disclosures paint a different picture, you have a problem. Differential disclosure is also a sign of trouble, where management says one thing in the shareholder letter but discloses another in the 10-K.
3. Compare non-operating/non-recurring items from year to year and adjust accordingly so that you can get a more clear picture of the operating results of the business
4. Compare cost differences year to year to see if there are one-time costs in one year that are not in another (making the comparison easier). Also, think about cost differences such as increased advertising spending that may depress EPS in the short term but increase EPS in the long-term as dollars increase/spending decreases.
5. Watch A/R and Inventories. This is the most important part of the book. If A/R or inventories are rising faster than sales, this can be problematic. Inventory builds of finished products are especially troublesome as they signal lack of demand. This is especially problematic in businesses where inventory becomes obsolete quickly, like high tech and seasonal/fashion businesses. Inventory builds of raw materials are the opposite and likely reflect increasing production to meet demand. Decreases in inventories with increases in A/R might reflect the "hard sell," or channel stuffing.
6. Be wary of accounting changes as they can benefit EPS for years to come. For example, if useful life is increased, depreciation will be decreased for multiple years.
A few of the key concepts in the book:
1. Don't trust Wall Street analysts, and don't trust your auditor. Both have conflicting incentives (street analysts want to be liked by management, auditors get paid by the Company who they audit who also presents cross-selling business opportunities). Ultimately you have to look at and interpret financial statements for yourself.
2. It can be useful to compare the management tone in annual shareholder letters against what the 10-K SEC disclosures actually say. If management is excessively positive while the financials and SEC disclosures paint a different picture, you have a problem. Differential disclosure is also a sign of trouble, where management says one thing in the shareholder letter but discloses another in the 10-K.
3. Compare non-operating/non-recurring items from year to year and adjust accordingly so that you can get a more clear picture of the operating results of the business
4. Compare cost differences year to year to see if there are one-time costs in one year that are not in another (making the comparison easier). Also, think about cost differences such as increased advertising spending that may depress EPS in the short term but increase EPS in the long-term as dollars increase/spending decreases.
5. Watch A/R and Inventories. This is the most important part of the book. If A/R or inventories are rising faster than sales, this can be problematic. Inventory builds of finished products are especially troublesome as they signal lack of demand. This is especially problematic in businesses where inventory becomes obsolete quickly, like high tech and seasonal/fashion businesses. Inventory builds of raw materials are the opposite and likely reflect increasing production to meet demand. Decreases in inventories with increases in A/R might reflect the "hard sell," or channel stuffing.
6. Be wary of accounting changes as they can benefit EPS for years to come. For example, if useful life is increased, depreciation will be decreased for multiple years.
August 21, 2018
Recently, there was an article about Chinese IPOs in a Shanghai newspaper. The writer spoke to Yan Ding, head of Ceibs Research Center in Shanghai about the merits of investing in the avalanche of IPOs coming the market’s way this year. “If somebody asks me whether to invest in an IPO, my answer is ‘Yes’! If they should read the prospectus? ‘No’! If they should borrow money? ‘Yes’!” Feeling somewhat dizzy and rudderless, now seemed like a particularly good point in time to re-read Thornton O’glove’s classic Quality of Earnings, built on his ground- breaking monthly report with the same name first published in 1971. The report was conceived during the author’s early days working as a stock- broker in the 1960s, during which time an “issue craze” swept through the market, rendering prospectus-reading irrelevant. Considering today’s +40 percent opening-day rigged China IPOs, this reviewer for one hears alarm-bells ringing. Hence, entrée of the seminal work on how diligent reading of corporate accounting does matter over time.
Quality of Earnings first and foremost deals with market inefficiencies via secrets hidden in (almost) plain sight. Accounting is said to be the language of business and some companies tell more lies than others. But who is the chicken and where is the egg? The companies? Investors? Auditors? Clients of investors? Society? Chapter 7, dealing with the differences between shareholder reporting and tax reporting is a case in point. But then of course it all circles back to the meta-debate of whether any of this matters, i.e. will it impact stock prices during the fund manager’s tenure? Hence, the derogatory naming of these matters as “academic”. Wouldn’t the more appropriate designation be as part of the time-arbitrage playbook?
One of the most important questions upon re- reading the book is the issue of aging. Quality of Earnings is likely a cornerstone in most investors’ bookshelves, albeit somewhat dusty. But this 1987- book can certainly be read with your 2014 glasses on. But obviously, some aspects of breaking new ground are lost 27 years later. Howard Schilit’s Financial Shenanigans and Financial Fine Print by Michelle Leder are more contemporary examples of successor books. The common denominator is the passion of teaching the reader the importance of forensic study of the accounting. As they say, offense wins games but defense wins championships. Doing tedious, time-consuming, mostly dead-end forensic accounting work is tough. And it won’t make you the next-play hero. But over time plain ol’ number crunching is a requirement to avoid permanent losses of capital. And the reasoning and case studies in this book will help you on that path.
The book is organized alongside order-of- complexity, common-sensical first. I found the early chapters “Don ́t Trust Your Analyst” and “Don’t Trust Your Auditor” slightly clichéd and over- simplified. Despite the overflow of events in this direction since the book’s publishing, has anything really changed? Do portfolio managers read more 10Ks and proxy statements now, skipping sell-side reports? Not likely. As the book progresses through the common snake pits in the P&L – non- recurring income, tax-reporting, working capital, debt, accounting changes etc. - complexity is turned-up a notch. The main drawback is the lack of actuality aspect in the case studies. They are certainly instructive still, but it does require a more dedicated reader. Overall, the book certainly fits in the mold of literature whose modus operandi centers on the “give a man a fish and you feed him for a day, teach him how to fish and he’ll feed himself for life”. The irony of course is that the Quality of Earnings® report, Footnoted® et al, live off of unwilling fishers.
“Because the documents were lengthy, very few [people] would take time out to read them. Accordingly, I concluded that one could obtain some edge on the market by diligently reading a prospectus from cover to cover”. I believe this to be true today as well, even though Mr. Ding and his friend Mr. Market might burst out laughing.
Quality of Earnings first and foremost deals with market inefficiencies via secrets hidden in (almost) plain sight. Accounting is said to be the language of business and some companies tell more lies than others. But who is the chicken and where is the egg? The companies? Investors? Auditors? Clients of investors? Society? Chapter 7, dealing with the differences between shareholder reporting and tax reporting is a case in point. But then of course it all circles back to the meta-debate of whether any of this matters, i.e. will it impact stock prices during the fund manager’s tenure? Hence, the derogatory naming of these matters as “academic”. Wouldn’t the more appropriate designation be as part of the time-arbitrage playbook?
One of the most important questions upon re- reading the book is the issue of aging. Quality of Earnings is likely a cornerstone in most investors’ bookshelves, albeit somewhat dusty. But this 1987- book can certainly be read with your 2014 glasses on. But obviously, some aspects of breaking new ground are lost 27 years later. Howard Schilit’s Financial Shenanigans and Financial Fine Print by Michelle Leder are more contemporary examples of successor books. The common denominator is the passion of teaching the reader the importance of forensic study of the accounting. As they say, offense wins games but defense wins championships. Doing tedious, time-consuming, mostly dead-end forensic accounting work is tough. And it won’t make you the next-play hero. But over time plain ol’ number crunching is a requirement to avoid permanent losses of capital. And the reasoning and case studies in this book will help you on that path.
The book is organized alongside order-of- complexity, common-sensical first. I found the early chapters “Don ́t Trust Your Analyst” and “Don’t Trust Your Auditor” slightly clichéd and over- simplified. Despite the overflow of events in this direction since the book’s publishing, has anything really changed? Do portfolio managers read more 10Ks and proxy statements now, skipping sell-side reports? Not likely. As the book progresses through the common snake pits in the P&L – non- recurring income, tax-reporting, working capital, debt, accounting changes etc. - complexity is turned-up a notch. The main drawback is the lack of actuality aspect in the case studies. They are certainly instructive still, but it does require a more dedicated reader. Overall, the book certainly fits in the mold of literature whose modus operandi centers on the “give a man a fish and you feed him for a day, teach him how to fish and he’ll feed himself for life”. The irony of course is that the Quality of Earnings® report, Footnoted® et al, live off of unwilling fishers.
“Because the documents were lengthy, very few [people] would take time out to read them. Accordingly, I concluded that one could obtain some edge on the market by diligently reading a prospectus from cover to cover”. I believe this to be true today as well, even though Mr. Ding and his friend Mr. Market might burst out laughing.
August 29, 2023
After 36 years this book is still relevant, although things have changed quite a bit. I find the explanations very clear and the calculation exercises a good practice in doing thorough security analysis. If you want some inspiration for red flags to look for in financial statements, or if you want to get some practice in adjusting income statements, this is great material. If you want a clear guide for best practice to deal with accounting/valuation issues today, however, it is a bit outdated.
How so? Some of the advice is outdated, in the sense that best practice in security analysis today already encompasses the authors advice, or has come up with better solutions yet. Take the example of accounting for interest income, which could be very high at the then prevailing interest rates in the 80's. In the case of one company which issued stock at the beginning of the year, the proceeds of which then generated interest income for the year only to be used for repurchasing shares at the end of the year. The author goes through a cumbersome exercise of taking out these numbers as being "extraordinary income" for that year, to make the per-share earnings better reflect the operations of the business. I think it is quite common today to use EV/EBIT valuation which takes away this (and many other) problems in how P/E ratios can be skewed by non-operating items on the income statement.
Some other suggested fixes are just very hard to justify at all. For insurance companies carrying securities at cost on their balance sheet, earnings can be engineered by selling of some investments at a gain. This can be done even if the portfolio as a whole is trading at less than cost, as long as some individual holdings are trading at a premium. Once again, the author choses to classify such earnings as non-operational/non-recurring, which to me seems to substitute one problem for another. Why not replace the number in the balance sheet (cost of investments) with their market value? We could then ignore realized gains/losses from the income statement and perhaps put the total gains from investments (both realized and unrealized) into the "net financial income" section of the income statement. Again, this would prove EV/EBIT to to be more valuable than P/E.
Many issues in accounting still remain today, such as changes in depreciation method, realized profits from the sale of wholly-owned subsidiaries, changes in advertising expenses, one-time write-offs by new management, etc. Also, new issues in accounting constantly develop, since accounting is only a model of reality and models are always in a process of being refined and adjusted. So if you read this book with an open mind into the author's thinking, you might be able to find your own way of dealing with these issues. I think this is the greatness of this book. If you read something more modern, the problem is that it has already been "priced in" by the markets, so you'd be better of deriving some general principles and creating your own adjustment tools. This book does a great job of getting you there.
The subtitle's promise of finding out "how much money a company is really making" is a bit misleading. O'glove's analysis mostly focuses on adjusting income statements in one year to better compare to previous years, rather than to bring them to some absolute correct level. It is a good method for adjusting how fast a business is growing however, which is at least of as much importance, especially around inflection points.
How so? Some of the advice is outdated, in the sense that best practice in security analysis today already encompasses the authors advice, or has come up with better solutions yet. Take the example of accounting for interest income, which could be very high at the then prevailing interest rates in the 80's. In the case of one company which issued stock at the beginning of the year, the proceeds of which then generated interest income for the year only to be used for repurchasing shares at the end of the year. The author goes through a cumbersome exercise of taking out these numbers as being "extraordinary income" for that year, to make the per-share earnings better reflect the operations of the business. I think it is quite common today to use EV/EBIT valuation which takes away this (and many other) problems in how P/E ratios can be skewed by non-operating items on the income statement.
Some other suggested fixes are just very hard to justify at all. For insurance companies carrying securities at cost on their balance sheet, earnings can be engineered by selling of some investments at a gain. This can be done even if the portfolio as a whole is trading at less than cost, as long as some individual holdings are trading at a premium. Once again, the author choses to classify such earnings as non-operational/non-recurring, which to me seems to substitute one problem for another. Why not replace the number in the balance sheet (cost of investments) with their market value? We could then ignore realized gains/losses from the income statement and perhaps put the total gains from investments (both realized and unrealized) into the "net financial income" section of the income statement. Again, this would prove EV/EBIT to to be more valuable than P/E.
Many issues in accounting still remain today, such as changes in depreciation method, realized profits from the sale of wholly-owned subsidiaries, changes in advertising expenses, one-time write-offs by new management, etc. Also, new issues in accounting constantly develop, since accounting is only a model of reality and models are always in a process of being refined and adjusted. So if you read this book with an open mind into the author's thinking, you might be able to find your own way of dealing with these issues. I think this is the greatness of this book. If you read something more modern, the problem is that it has already been "priced in" by the markets, so you'd be better of deriving some general principles and creating your own adjustment tools. This book does a great job of getting you there.
The subtitle's promise of finding out "how much money a company is really making" is a bit misleading. O'glove's analysis mostly focuses on adjusting income statements in one year to better compare to previous years, rather than to bring them to some absolute correct level. It is a good method for adjusting how fast a business is growing however, which is at least of as much importance, especially around inflection points.
April 28, 2022
Especially the parts where tangible examples are provided (most chapters of the book) are quite valuable. Despite the use of lots of numbers things are still kept relatively reader friendly compared to other investment books. Would recommend
March 14, 2023
3.5/5
A bit dated as can be expected from a book over 35 years old, though the principles and concept remain robust to this day. Chapters 7-12 had the most important takeaways and worth keeping as a reference, while the beginning chapters couldve been summarised in half the length. Key chapters: 7. Shareholder vs tax reporting, 8. A/R and inventories 9. Debt & Cash flow analysis, 11. Accounting Changes 12. Restructuring.
A/R and Inventories chapter is incredibly insightful; the knowledge of how to disect working capital movements is extremely pertinent to any equity or credit analysis of a company.
A bit dated as can be expected from a book over 35 years old, though the principles and concept remain robust to this day. Chapters 7-12 had the most important takeaways and worth keeping as a reference, while the beginning chapters couldve been summarised in half the length. Key chapters: 7. Shareholder vs tax reporting, 8. A/R and inventories 9. Debt & Cash flow analysis, 11. Accounting Changes 12. Restructuring.
A/R and Inventories chapter is incredibly insightful; the knowledge of how to disect working capital movements is extremely pertinent to any equity or credit analysis of a company.
June 5, 2016
author slightly over-confident and a few examples are over-interpreted a bit too much to lead to a strong conclusion. But it is thought provoking and content rich book.
July 7, 2022
This book teaches us about the information investors commonly overlook when analysing the financial performance of a company. It teaches us about the important sections of financial statements and annual reports that are commonly overlooked and deserve special analysis.
Though some of the information is dated, it also offers many timeless principles about investing. The writer mainly uses practical examples of accounting gimmicks used by companies to inflate their share earnings, and how to avoid pitfalls by investing in these companies. It also offers examples of opportunities where an investor can profit from underestimated share earnings.
This book is especially relevant to serious investors in current times when stock prices are inflated, and decisions to invest must be carefully considered. This book can be recommended to those who are already familiar with accounting concepts and wish to broaden their knowledge.
January 20, 2024
In the world of stocks, people generally prefer illusion to reality. Thornton makes a compelling case based on incentives as to why you should never trust an analyst and never trust an auditor, instead learn to do the work yourself. Through 12 chapters of dense, witty, example-laden text, Thornton captures several of the key ways corporations conceal the real earnings of their companies
Favorite Chapters
- Non operating / Non recurring income: Can't describe it with precision, but I know it when I see it
- Increasing and decreasing expenses: SG&A cuts both ways
- Shareholder vs Tax Books: A good accountant knows income is whatever you want it to be
- Accounts Receivable & Inventory: Spotting smokeless smokestacks
Favorite Chapters
- Non operating / Non recurring income: Can't describe it with precision, but I know it when I see it
- Increasing and decreasing expenses: SG&A cuts both ways
- Shareholder vs Tax Books: A good accountant knows income is whatever you want it to be
- Accounts Receivable & Inventory: Spotting smokeless smokestacks
April 28, 2021
A very good read on how to review financial statements and read what’s behind the numbers. The author gives plenty of examples clearly showing traps and minefields in management letters, EPS results, and balance sheet representation. Concludes that the individual investor can beat Wallstreet large investors by investing time in analyzing financial statements and evaluating fundamentals. Quality of books and quality of earnings matter on the long term.
August 18, 2023
It is an "ok book". One can learn a bit about what to focus on when reading financial reports.
In my opinion, it was a bit random and just scratched the surface.
If you know something about accounting, you might find the most information in the book redundant, but still there might be one or two new facts. Hence, the book is worth reading.
Maybe the most important thing to mention: the author seems to be rather short-term focus and sometimes seems to miss the forest for the trees.
In my opinion, it was a bit random and just scratched the surface.
If you know something about accounting, you might find the most information in the book redundant, but still there might be one or two new facts. Hence, the book is worth reading.
Maybe the most important thing to mention: the author seems to be rather short-term focus and sometimes seems to miss the forest for the trees.
January 1, 2021
Bill Ackman recommends this book as a batch of books to reach if you plan to start investing. It explain the multiples ways that financial statements show potential traps in future growth of companies and cases where growth will happen.
From tax accounting to dividends there about everything here.
Requires user to know some financial concepts for a better understanding.
From tax accounting to dividends there about everything here.
Requires user to know some financial concepts for a better understanding.
January 16, 2023
Excellent guide to reading in between the lines and seeing through common accounting tactics public companies use to dress up earnings. Replete with case studies and examples. Four stars because it was a bit dry—not sure many people care for the painstaking walk-through of various forms of depreciation & amortization. But maybe some "accounting alpha" for those who care to find it.
February 5, 2023
Book covers all the aspects related to earnings which are not in general i.e. not related to general operations of the company, a must read for retailers who are somehow or other get intangle in stock just for showing earnings growth. The books just not deal with theory, but it explains with many case studies.
August 15, 2021
Thornton was very thorough with his examples, though it was rather dense at times due to the amount of words used to explain changes for instance. Nonetheless, good read with a lot of empirical evidence provided as credible sources.
December 3, 2022
Principles of analysis remain as valuable today as when this text was written. However, the dramatic change in tax treatment of corporate earnings (especially for multinationals) does render the text more useful as a guide than as a direct copy-paste into your analytical toolkit.
October 26, 2017
Very dry, but practical and eye opening
February 23, 2018
Truly amazing classical book on accounting gimmicks. You won’t believe but it is thrilling and flows as a good detective book. Thumbs up.
October 4, 2018
Interesting insights on what to look to. Nothing major. A little bit difficult to read though.
March 3, 2020
The simplicity on how he provides ideas and examples is really amazing. Another book that I will need to review to reap its true ideas and rewards.
May 17, 2020
A difficult book, but worth reading. Especially for short-term investors.
September 9, 2020
Would have been a fantastic book back in the day (1980s), but a lot of the concepts are outdated now, putting too much emphasis on PE ratios
December 18, 2020
Informative but very dry reading
February 16, 2021
Adequate handbook for novice investors looking to learn how to inspect financial statements
April 19, 2021
You will never look at accounting and financial disclosures the same again.
April 27, 2023
25 days, Absolute Speed: 8.88 pages per day
September 29, 2023
Very insightful
December 21, 2023
Wow, this book is a must if you want to become an investor.
March 24, 2024
Very simple recount of strategies analysts' can use to engage the quality of a co's earnings.
Doesn't overcomplicate anything and supplements theories with concise examples.
Doesn't overcomplicate anything and supplements theories with concise examples.
November 10, 2016
GOOD BOOK
July 15, 2015
The language used in this book is very layman but the idea is great! I like the way the author brings its reader through baby steps in explaining something difficult in an easy to understand manner. With all the financial engineering in making the figures look pretty, this book has shown me several techniques in unmasking these figures to draw out the (close to) true earnings of a given company.
I would definitely recommend this to anyone that is keen to drill a company's profit earnings and also give it a 5 star but the book is rather old and some of the ideas here are just no longer applicable (not in my country at least). It goes without saying but the book is more catered towards the US market so unless you have a time machine that can send you back to the 80s, and you are in a market with very similar accounting and tax standards as the US, you will not be able to utilise 100% of this book. Then again, it is a very simple book so it probably would not take up too much of your time should you choose to read it.
I would definitely recommend this to anyone that is keen to drill a company's profit earnings and also give it a 5 star but the book is rather old and some of the ideas here are just no longer applicable (not in my country at least). It goes without saying but the book is more catered towards the US market so unless you have a time machine that can send you back to the 80s, and you are in a market with very similar accounting and tax standards as the US, you will not be able to utilise 100% of this book. Then again, it is a very simple book so it probably would not take up too much of your time should you choose to read it.
Displaying 1 - 30 of 49 reviews