Every year industry market analysts evaluate earnings quality. Let’s review what it means to conduct a financial assessment for quality earnings in the context of executive compensation disclosures. Earnings quality is the degree of reliability in reported earnings to reflect a company’s true earnings and to help predict future earnings. What analysts and investors are trying to ascertain from reviewing earnings quality is the company’s sustainable revenues, which is critical input in determining a company’s market valuation and overall long-term organization effectiveness.

Some variables companies use to measure earning quality are:

  • Margins, gross or net.
  • Capital expenditures and R&D relative to industry/peer group.
  • Sales and administrative expenses relative to sales.
  • Significant change in effective tax rate.
  • Cost structure relative to industry/peer group.
  • Change in labor force.

The underlying framework to assess earnings quality is demarcating the earnings capabilities of the company as an ongoing business concern from outliers like one-time charges and acquisition/divestiture issues. For companies that tend to use conservative accounting practices, there’s a bias toward higher earnings quality. Whirlpool and GE beat market expectations for revenue growth this year. When you take a closer look as to how this growth was achieved, it is attributed to energy tax credits, not organic growth in operating profit or a basis in a sustainable revenue stream.

In addition to analysts that give “high” or “low” assessments of companies’ earnings, there are companies such as Starmine (a division of Thomson Reuters) and Standard & Poors that evaluate companies’ earning quality and issue ranking or scores. Starmine’s recent newsletter highlights Three D Systems as a high earnings quality company with a score of 96 (scale of 1 to 100, 100 being the highest) primarily due to Free Cash Flow (FCF), Net Operating Margin, and Return on Net Operating Assets (RONOA). In reviewing Three D Systems proxy disclosures related to executive compensation, the overall level of transparency is excellent. Here are some supporting observations in the proxy:

  • In addition to NEOs’ compensation, the compensation committee reviews all compensation requests for employees earning 200K or more in base salary.
  • Executives’ and employees’ compensation strategy/philosophy is aligned, one in the same.
  • Comprehensive explanation of compensation risk and oversight (could be used for SOX audit).
  • Clawback and hedging policies “proactively” disclosed in proxy; currently, they are recommended, not required disclosures.
  • Specifically mentioned formal succession planning process; knowing they are “on-top” of the leadership pipeline is key to sustainability of the organization’s effectiveness.

To read Starmine’s newsletter and Three-D’s proxy, see http://www.starmine.com/newsletters/index.phtml?newsletter=eqa and http://www.3dsystems.com/investors/datafiles/3DSystems-2011-Proxy-Statement.pdf.