Revenue is the top line of the income statement for a reason: it is the lifeblood of any company.
Management persist in massaging revenue in numerous ways to mask underlying weakness because they can. Because the rest of the financials depend on revenue, it deserves the most scrutiny. Any doubt about the quality or sustainability of revenue throws the rest of the financial model into question.
Accurate revenue is crucial to confidence in cash flow, because the bottom line of the income statement is the top line of the cash flow statement.
Revenue is recognized when it is earned, but the timing is open to interpretation. Revenue can be "realized", "realizable", and "earned" - allows for wiggle room.
The top metric to determine the quality of a company's revenue is days sales outstanding (DSO). DSO = 91.25 x (AR/Quarterly Revenue). We want to compare the quarter's DSO both year-over-year (to account for seasonality) as well as sequentially (quarter-over-quarter). The practice we want to catch is a change in payment terms that borrows revenue from the future to make this quarter look better than it is. Higher DSO has nothing to do with collections but everything to do with revenue recognition.
If management alludes to a "heavily back end loaded quarter" it may mean the company signed deals at generous terms near the end of the quarter in order to feed the Street. Raise your eyebrows if you hear "hockey stick growth" or "non-linear growth" for anything but a hypergrowth company.
Anytime discretion enters into the equation, there is the opportunity to manipulate the numbers. Management my underestimate costs incurred or overestimate the proportion completed in a given period, providing a boost to current results at the expense of future reporting periods (watch out in Percentage of Completion accounting).
When a company derives an increasing portion of its revenue from affiliated entities (related parties of some sort), investors should be concerned.
Keep an eye on the deferred revenue number (liability on the balance sheet offset against a cash asset received but revenue not yet realized).
Watch out for nonmonetary transactions as a boost to reported revenue (barter).
Watch out for bill-and-hold revenue - vendor invoices the customer and recognizes the transaction as revenue, but the products aren't shipped until later.
Watch out for one time gains reported as revenue or interest income falsely counted as regular income. One time revenue events can obscure real underlying growth or organic growth. Strip them out.
Look for growth in sales-type leases (where a company can lease a product but treat it as a sale).
Be wary when a company purchases a distributor - it can slip by some double counting.
Any change in revenue recognition policy should raise eyebrows and warrant increased scrutiny. Even a change to a more conservative policy can boost results by double counting revenue.
Wall St has a nasty habit of seeing write-offs as one time events and forgetting about them, when in fact they are prima facie evidence of weakness in accounting systems.
Showing posts with label revenue recognition. Show all posts
Showing posts with label revenue recognition. Show all posts
Thursday, July 3, 2014
Wednesday, July 2, 2014
Behind The Numbers - The Real Risk of Stock Investing
Most stocks lose money.
Study (1983-2007): 39% of stocks had a negative total return (2 out of 5 stocks are money losing investments); 18% lost at least 75% of their value; 64% underperformed the Russell 3000 (most stocks can't keep up with a diversified index); a small minority of stocks significantly outperformed their peers.
The best performing stocks (top 25%) accounted for all the gains. The bottom 75% collective had a total return of 0%.
It is obvious that a few stocks are responsible for all the market's gains. This shows why it is essential to avoid the losers - and that there are valuable opportunities to profit from shorting.
Beating inflation is likely an accident of birth.
Graham called "firmness of character" - the ability to keep your own emotional counsel.
To buy any individual stock, let alone take any contrary market position, you have to be able to identify earnings quality concerns in your companies financials, and you have to stay away from anything you don't understand well enough to do so.
Indexes are the best of poor alternatives for anyone not investing in individual stocks. The minute that investors choose stocks, they have to learn about earnings quality.
Poor bases for shorting: Overvaluation (can continue indefinitely); fads (can do very well against the odds for a long time); frauds (hard to identify until after the fact); identifying business models that will fail (when they will fail is all but impossible to know); the short seller who "needs to be right". Short selling on those bases is simply too hard, too risky, and unnecessary.
We recommend waiting until there is aggressive revenue recognition, weakening balance sheets, and deteriorating cash flow trends. Wait until there are negative catalysts for profits in the near future.
Finding a fad and simply shorting it can never be called risk management. It adds risk because it increases the chance of margins calls and being stopped out.
Does it hurt to wait until a stock has cracked before shorting? Ans. No. And this is one fundamental thing about short selling that is so obvious that it is confounding-and ignored. You make as much money shorting a stock that falls from $70 to $5 (93%) as one that falls from $100 to $5 (95%). Waiting for the right time isn't going to cost you money. The time to short will be only when accounting analysis shows that the revenues aren't real or aren't sustainable.
Short sellers take an unnecessary risk by focusing on fraud because frauds are preceded by accounting issues that can be identified. The problem is that constantly looking for fraud can cloud your judgment.
Our process focuses on revenue. Until we see revenue problems-revenues that may be falling while inventories build and credit terms lengthen-we won't bet on whether a company is a fraud.
It is rational to want to short a fraud, but the correct focus is not on whether a manager is lying, but on whether a company is practicing financial chicanery.
Short sellers rightly look for business models that can fail, but they can't know when to short without a specific catalyst that, if it materializes, will kill the company's model and let them profit from a short.
When the money tap is turned off, a business model that depends on huge leverage suddenly dries up and becomes unsustainable. That's the catalyst.
The time to short is not when you think a business model can't survive. The time is when the numbers suggest that management is covering up poor performance and when the stock has already begun to fall.
When buybacks are not opportunistic, they mask options grants or - worse - raise the question of whether they are specifically to transfer shareholder wealth to option holders and insider sellers.
Days Sales Outstanding (DSO): the time between when the company makes a sale and receives the revenue.
Earnings quality analysts don't short without analyzing short interest and days to cover in order to avoid the squeezes that lead to margin calls, covering at any cost, and catastrophic losses.
If a lot of shares are sold short and the stock is thinly traded, the slightest good news could be very bad.
Float means the shares that can be freely traded any given day, excluding restricted shares, insider holdings, and shares held by those with more than 5% ownership.
Instead of needing to be right, wait for the obvious indicator of accounting trouble and act then. You have your negative catalyst.
Financial analysis prevents the mistake where an investor unearths an accounting issue but does not understand whether it matters or not in the real world.
The BEST SITUATION IS AGGRESSIVE REVENUE RECOGNITION MASKING SOFTENING DEMAND.
Study (1983-2007): 39% of stocks had a negative total return (2 out of 5 stocks are money losing investments); 18% lost at least 75% of their value; 64% underperformed the Russell 3000 (most stocks can't keep up with a diversified index); a small minority of stocks significantly outperformed their peers.
The best performing stocks (top 25%) accounted for all the gains. The bottom 75% collective had a total return of 0%.
It is obvious that a few stocks are responsible for all the market's gains. This shows why it is essential to avoid the losers - and that there are valuable opportunities to profit from shorting.
Beating inflation is likely an accident of birth.
Graham called "firmness of character" - the ability to keep your own emotional counsel.
To buy any individual stock, let alone take any contrary market position, you have to be able to identify earnings quality concerns in your companies financials, and you have to stay away from anything you don't understand well enough to do so.
Indexes are the best of poor alternatives for anyone not investing in individual stocks. The minute that investors choose stocks, they have to learn about earnings quality.
Poor bases for shorting: Overvaluation (can continue indefinitely); fads (can do very well against the odds for a long time); frauds (hard to identify until after the fact); identifying business models that will fail (when they will fail is all but impossible to know); the short seller who "needs to be right". Short selling on those bases is simply too hard, too risky, and unnecessary.
We recommend waiting until there is aggressive revenue recognition, weakening balance sheets, and deteriorating cash flow trends. Wait until there are negative catalysts for profits in the near future.
Finding a fad and simply shorting it can never be called risk management. It adds risk because it increases the chance of margins calls and being stopped out.
Does it hurt to wait until a stock has cracked before shorting? Ans. No. And this is one fundamental thing about short selling that is so obvious that it is confounding-and ignored. You make as much money shorting a stock that falls from $70 to $5 (93%) as one that falls from $100 to $5 (95%). Waiting for the right time isn't going to cost you money. The time to short will be only when accounting analysis shows that the revenues aren't real or aren't sustainable.
Short sellers take an unnecessary risk by focusing on fraud because frauds are preceded by accounting issues that can be identified. The problem is that constantly looking for fraud can cloud your judgment.
Our process focuses on revenue. Until we see revenue problems-revenues that may be falling while inventories build and credit terms lengthen-we won't bet on whether a company is a fraud.
It is rational to want to short a fraud, but the correct focus is not on whether a manager is lying, but on whether a company is practicing financial chicanery.
Short sellers rightly look for business models that can fail, but they can't know when to short without a specific catalyst that, if it materializes, will kill the company's model and let them profit from a short.
When the money tap is turned off, a business model that depends on huge leverage suddenly dries up and becomes unsustainable. That's the catalyst.
The time to short is not when you think a business model can't survive. The time is when the numbers suggest that management is covering up poor performance and when the stock has already begun to fall.
When buybacks are not opportunistic, they mask options grants or - worse - raise the question of whether they are specifically to transfer shareholder wealth to option holders and insider sellers.
Days Sales Outstanding (DSO): the time between when the company makes a sale and receives the revenue.
Earnings quality analysts don't short without analyzing short interest and days to cover in order to avoid the squeezes that lead to margin calls, covering at any cost, and catastrophic losses.
If a lot of shares are sold short and the stock is thinly traded, the slightest good news could be very bad.
Float means the shares that can be freely traded any given day, excluding restricted shares, insider holdings, and shares held by those with more than 5% ownership.
Instead of needing to be right, wait for the obvious indicator of accounting trouble and act then. You have your negative catalyst.
Financial analysis prevents the mistake where an investor unearths an accounting issue but does not understand whether it matters or not in the real world.
The BEST SITUATION IS AGGRESSIVE REVENUE RECOGNITION MASKING SOFTENING DEMAND.
Subscribe to:
Posts (Atom)