Technology One (TNE) released their H1 19 results last week. Company guidance for profit before tax (PBT) was a bit below market expectations and as a result the shares fell post result. All pretty standard stuff.
There were however, two quite interesting aspects from the result:
- The first was the restatement of FY 18 results to reflect new accounting standards. According to TNE, FY 18 PBT was either:
– $66.5m as originally reported.
– $24.8m as required under AASB15
– $50.8m based on AASB15 with pro-forma capitalized development.
- Despite this clear evidence that reported profits for the business are primarily a function of which accounting regime is used, the analyst commentary around the result tended to focus primarily on … reported earnings and earnings guidance. In fact one piece of research I read did not even reference the change in R&D capitalization policy which saw approximately $30m p.a of additional expenses capitalized vs pcp.
In these two observations is the essence of earnings quality analysis as a tool for investors. As Professor Sloan noted in his seminal paper:
“Stock prices act as if investors ‘fixate’ on earnings, failing to distinguish fully between the different properties of the accrual and cash flow components of earnings.”
At least as far as the TNE result goes, these words hold as true today as they did when first penned back in 1996.
What does Earnings Quality Mean?
To simplify, reported earnings are an estimate of underlying performance. These estimates are subject to error and bias, so at certain times reported earnings are a conservative estimate of underlying performance and at other times they are an aggressive estimate of this performance. Because the market tends to focus on the level of reported earnings and not their statistical significance, opportunities arise for investors.
One way to think of this is that reported earnings should come with confidence intervals. So TNE’s FY 18 profits might be reported as $50.8m with 95% confidence that real profits were somewhere between $25m and $67m.
To use one of the indicative illustrations that TNE are themselves so fond of using, the historical profit trend might look as follows: