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Stock Strategist

Earnings at These Two Firms Are Not Created Equal

With earnings just around the corner, we offer a few words on earnings quality.

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Given Wall Street's fixation on near-term earnings-per-share numbers, the market sometimes overlooks earnings quality--the underlying strength of a firm's reported profits. Before your eyelids drift shut, consider this: There's money to be made (and preserved) in the dry task of earnings-quality appraisal. An established body of research (Sloan (1996, 2002), Swanson and Vickrey (1997), Chan, Jegadeesh, and Lakonishok (2001), Collins and Hribar (2000), Penman and Zhang (2002)) shows that firms with high-quality earnings (i.e., strong cash earnings) tend to produce higher investment returns, while low-quality earnings are linked to underperformance.

Whether you wish to screen for earnings quality in prospective stock purchases or to track the earnings strength of firms you own already, we think the framework described below will be a handy addition to your investment tool belt. To illustrate, we serve up a couple of actionable ideas--the first, a 1-star, no-moat company with shaky profits; the second, a 5-star, wide-moat firm whose earnings are rock-solid.

Ryan McLean does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.