09 April 2007

Earnings Quality

MarketWatch had an interesting article, originally published in the Weekend Wall Street Journal, on earnings quality. It discusses the analytical work of Victor Germack of RateFinancials. We resonate with this firm's philosophy of eschewing buy/sell recommendations in favor of risk analysis and numerical ratings of companies. Their scale runs from 1 to 40, whereas our Overall gauge has limits of 0 and 100 (although very rarely do we see a score over 80).

To gain insight into earnings quality, our methodology gives considerable weight to inventory management. We also use the accrual ratio to see if earnings are driven by ops-driven free cash flow or accounting changes in the balance sheet (i.e., accruals). This approach is based on the ground-breaking work of Richard Sloan.

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