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Two firms, Topnotch and Lowdown, have developed new products through internal research. They both experience significant increases in earnings from sales of the products, which are expected to continue indefinitely into the future. The products are assumed to be manufacturable and salable using each company's existing capacity, and the products are of equal value for Topnotch and Lowdown. Will the earnings increases be perceived as equally valuable for the two companies?
The answer is probably not if Lowdown's earnings are perceived to be of lower quality because of certain patterns and behaviors that are thought to reduce the quality of earnings and hence the value of the signal associated with a change in earnings.
A firm that wants to provide a strong signal about future earnings performance should avoid giving the negative impression that earnings are low in quality. The capital market's perception of the quality of earnings may be as important as the underlying earnings number.
The term "earnings quality" has been deiced in various ways. One view of earnings quality relates to the overall permanence of earnings. That is, high-quality earnings reflect earnings that can be sustained for a long period. Another view relates earnings and stock market performance. Under this view the stronger the relation between earnings and market returns the higher the earnings quality.
THE EARNINGS QUALITY CONCEPT
The concept of earnings quality is not new. It evolved from the fundamental analysis notion of searching for undervalued and overvalued securities, which developed in the 1930s. An under-or overvalued security was one priced at less or more than its "true" or intrinsic value. This true value could be ascertained by carefully analyzing a company's financial statements for information that would suggest a company should be trading for more or less than the present market value. Implicit in this concept is the idea that the market is not efficient and that a firm's stock price moves only gradually toward its true value.
The concept of earnings quality became better known in the late 1960s and early 1970s. One of the best known advocates of the earnings quality approach to financial analysis, Thornton L. O'Glove, published Quality of Earnings, an investor advisory report. O'Glove's approach involves detailed analysis of the components of earnings in...