In a research report released yesterday, Merrill Lynch identified the six key income statement and balance sheet measures that should be reviewed when evaluating corporate earnings. The measures were developed in consultation with Harvard Business School Professor David Hawkins, who is Merrill Lynch's consultant on accounting issues. The report is entitled, "Quality of Earnings: Towards a 360 degrees View of Reality."
Four of the six measures can be calculated from historical financial statements prepared in accordance with generally accepted accounting principles (GAAP). The two remaining measures require input from Standard & Poor's. The six measures are:
- Pretax return on capital
- Cash realization
- Productive asset reinvestment
- Tax rate
- Common stock ranking
- Credit rating
"We believe these measures are useful in monitoring changes in the ability of a company's assets to generate consistent income and that these tools can assist in spotting changes before they are reflected in a company's income statement," said Professor Hawkins.
As explained in the report, the six metrics reflect what Professor Hawkins and Merrill Lynch consider to be the six key characteristics of high quality earnings, (i.e., earnings that are earned by superior returns on total capital, close to being realized in cash, repeatable because of the level of capital invested in assets, not dependent on transitory tax rates, and not at risk because of high financial leverage and dividend obligations.)
Next steps, according to Deepak Raj, senior vice president and head of Merrill Lynch global equity research, include use of the framework by Merrill's analysts in their daily fundamental analysis, as well as creation of special quality-of-earnings sector reports.