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Tuesday, October 26, 2010

It is Q2 results season – can you spot good earnings management?

Now that the Coal India IPO is successfully out of the way (i.e. with considerable oversubscription), one of the major uncertainties about the future direction of the Indian stock markets has been removed. There was no large-scale selling visible in the secondary markets – as the FIIs brought in new funds to subscribe to the IPO.

The focus has now shifted to the Q2 results season. The continued volatility in the Sensex and Nifty is an indication that the investing community is uncertain about how the results will pan out. The uncertainty is compounded by the fact that the Sensex is trading around the 20000 level – just below its Jan ‘08 all-time high.

Those who believe that expected good results have already been ‘discounted’ by the current stock market index levels are bearish, and worried about a huge 2008-like fall. Those who think that earnings will surprise on the up side are bullish, and betting on a 25000 Sensex target.

Why does the quarterly results season generate so much tension, anxiety and uncertainty amongst traders and investors? Earnings, or net profits, are often treated as the most important factor in a financial statement. For estimating the ‘intrinsic value’ of a company, the present value of its future earnings is calculated using the Discounted Cash Flow (DCF) method. Increased earnings has a salutary effect on the stock’s price. A drop in net profit leads to selling.

What is earnings management and why do companies indulge in it? Simply put, earnings management (as opposed to ‘cooking the books’ a la Satyam Computers) means using legal accounting methods to ‘dress up’ the net profit figure to meet or exceed analysts’ expectations.

Why would a company resort to earnings management? The cynical answer is: the top executives want to save their skin and ensure that their own company stock holdings don’t drop in value. Even a well-respected multinational like Hindustan Unilever resorted to earnings management when they declared their Q2 results yesterday.

The headline in the business page of a leading daily was: ‘Lever posts 32% rise in net’. To be fair, the company did mention that exceptional gains of Rs 40 Crores during the period compared with exceptional costs of Rs 135 Crores in the same period of the previous year led to the 32% growth. Without the exceptional items, the profit grew only 6.8%.

How can you spot whether a company is resorting to earnings management or not? The disclosure details during quarterly results announcements are not adequate to spot all the legal (and illegal) accounting methods adopted by different company managements. But investors would do well to look beyond the headlines and interim dividend announcements to check the details that are published.

Any unusual increase or decrease in earnings is a ‘red flag’ and needs to be investigated further. Some times, excellent earnings announcements by not-so-excellent companies are accompanied by various fund-raising plans. The idea being to cash-in on the good feelings generated amongst the investing community.

Pay careful heed to the reasons for the fund-raising. If it is for increasing production capacities or entering new geographical territories, it is a positive. But raising money to reduce/pay-off earlier debts, or to pay taxes and dividends on earnings that do not generate a corresponding positive cash flow from operations is a negative.

Managers that always promise to ‘make the numbers’ will at some point be tempted to ‘make up the numbers’ – Warren Buffett

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