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Disclaimer
Earnings Sustainability: The Key To Your Investing Future
Evaluating company valuations for investment purposes is a difficult task. Frequently, investors will use valuation ratios, such as the price-earnings (P/E) ratio, and compare them with similar companies to determine if its relatively cheap or expensive. In conjunction with ratios like the P/E, investors should look at the sustainability of the companys earnings. A company that reports abnormally high earnings in one period may see the price of their stock shoot up along with their P/E ratio. But will those earnings persist to justify the higher valuations? By analyzing the sustainability of earnings, investors can get a sense of how earnings will behave in the future.
Restructuring Charges / Write-offs
Often, restructuring charges or write-offs by a company are treated as a one-time expense and ignored by investors. However, when doing due diligence during your investment process, you should always pay attention to these items - they could be anything but one-time. For example, a company that has to perform a significant write down on their inventory will continue to be affected by the write down, through a lower cost of goods sold in future years. Similarly, if the company decides that their equipment or plants requires a write down, future depreciation will also be lower. Both these items directly impact future net income, yet are often thrown by the wayside. (For more on write-offs, also take a look at Common Clues Of Financial Statement Manipulation.)
Advertising Expenses
Some companies depend on certain core activities to sustain their earnings. For many companies in which brand recognition is especially important, marketing and advertising expenses are keys on which to focus. Often, a company will create a temporary boost in earnings by lowering their advertising expenses in the current period, but this action may be at the expense of future net income.
To analyze advertising expenses, simply calculate the amount spent on advertising during the period as a percentage of revenues. Compare the percentage spent on advertising over the course of a few years (three to five years is usually good). Large increases or decreases in this expenditure should be investigated further. For example, lets take a look at Coca Colas advertising expenses (in millions) for 2006-2008.
-- 2008 2007 2006
Net Revenues 31944 28857 24088
COGS 11374 10406 8164
Gross profit 20570 18451 15924
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