I believe that adopting the concept of core earnings makes a signif-
icant move in the direction of standardizing profit statements and is
currently the best way to measure a firm’s earnings potential.^21 One
should not underestimate how important this is. A typical firm in
today’s market sells for about 20 times yearly earnings. This means that
only one-twentieth, or 5 percent, of its price depends on what happens
in the next 12 months and 95 percent of its price depends on what hap-
pens after that. That is why when we calculate earnings, accounting de-
cisions should distinguish between any one-time gains and losses that
are not expected to be repeated and those that have implications for fu-
ture profitability. This is what Standard & Poor’s accomplished with
core earnings.
EARNINGS QUALITY
Going beyond Standard & Poor’s core earnings, another way to measure
the quality of earnings is by examining a firm’s accruals, which is defined
as accounting earnings minus cash flows.
A firm with high accruals may be manipulating its earnings, and
this could be a warning of problems in the future. Alternatively, low ac-
cruals may be a good sign that earnings are being conservatively esti-
mated by the firm.
There is strong evidence that firms with low accruals have much
higher stock returns than firms with high accruals. Richard Sloan, a pro-
fessor at the University of Michigan, was the first to determine that a
high level of accruals was related to subsequent poor earnings and low
stock returns.^22
Sloan found that from 1962 through 2001, the difference between
the firms with the highest-quality earnings (lowest accruals) and those
with the poorest-quality earnings (highest accruals) was a staggering 18
percent per year. Further research indicated that despite the importance
of accruals, Wall Street analysts did not take this into account when fore-
casting future earnings growth.
108 PART 2 Valuation, Style Investing, and Global Markets
(^21) The core earnings concept is the brainchild of David Blitzer, managing director and chairman of
the Index Committee, Robert Friedman, Howard Silverblatt, and others.
(^22) Richard Sloan, “Do Stock Prices Reflect Information in Accruals and Cash Flows about Future
Earnings?”Accounting Review, vol. 71 (1996). High levels of accruals are also associated with more
SEC enforcement actions, earnings restatements, and class action lawsuits, all of which have nega-
tive implications for stock returns. Also see Richard Sloan, Scott Richardson, Mark Soliman, and
Irem Tuna, “Accrual Reliability, Earnings Persistence and Stock Prices,”Journal of Accounting and
Economics, vol. 39 (2005).