The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

EARNINGS

A commonly used measure of a company’s performance over a period of time is its earnings, which is often stated in terms of a return—that is, earnings scaled by the amount of the investment. But earnings can really mean many different things depending on the context. If a common stock analyst is evaluating the performance of a company’s operations, the focus is on the operating earnings of the company—its earnings before interest and taxes, EBIT. If the analyst is evaluating the performance of a company overall, the focus is upon net income, which is essentially EBIT less interest and taxes. If the analyst is evaluating the performance of the company from a common shareholder’s perspective, the earnings are the earnings available to common shareholders—EBIT less interest, taxes, and preferred stock dividends. Finally, if the analyst is forecasting future earnings and cash flows, the focus is on earnings from continuing operations. Therefore, it is useful to be very specific about the meaning of “earnings.”

There is a possibility that reported financial information may be managed by the judicious choice of accounting methods and timing employed by management. In particular, earnings can be managed using a number of accounting devices. There are many pressures that a company may face that affect the likelihood of earnings management. These pressures include executive compensation based on earnings targets, reporting ever-increasing earnings (especially when the business ...