Quality of earnings

Quality of earnings is usually a rather ill defined idea of how good or real earnings are, although some academics have attempted to devised numerical measures of it.

Earnings are typically considered high quality if they:

• are sustainable, rather than the results of one offs,
• reflect the performance of the business, rather than arising as a result of accounting practices (whether conventions such as accural and historical cost accounting, or deliberate boosting of numbers),
• result in cash generation — i.e., cash conversion is high,
• come from core businesses,
• are low risk, stable, predictable, rather than “lumpy” with wide variations from year to year,
• are defensive rather than cyclical.

There are often links between these factors, but not invariably: it is not, for example, unusual for a business to have cash generative earnings that are sustainable in the long term, but which are subject to wide, unpredictable variations from year to year.

The predictability of earnings is sometimes more specifically referred to as earnings visibility.