Judging the earnings quality for any company requires a thorough review of quarterly and annual financial statements. It is important to understand how the company makes money—the sources of revenue (both organic and acquired) and trends in those sources. These revenue streams need to be evaluated based on organic growth (e.g. stealing market share, new product launches, etc.) and acquired growth (buying a company or product) to ascertain whether the core business is growing or slowing to appropriately value the company on a sustainable growth basis.

Judging the quality of earnings can also be influenced by the accounting methodology a company chooses to employ. For example, if a manufacturing company chooses to capitalize expenses, then the costs will appear lower and profits will appear higher for that time period. But this is just a timing issue; eventually, those expenses will need to be realized. Other accounting examples look at inventory valuation, allowance for doubtful accounts, revenue recognition policies, or accounts payable trends. In fact, one of the easier ways to determine if a company has high earnings quality is to simply compare the net income with the cash flow from operations. Cash usually never lies. (For more on quality of earnings refer to How To Evaluate The Quality Of EPS ).

Analyzing Facebook’s Earnings Quality

Facebook ‘s stock (FB ), not unlike other companies, can be judged on it earnings quality. Its primary source of revenue is from advertising (approximately 90% of earnings, according to the company’s SEC filings). FB has made a strategic decision to focus on monetizing its mobile presence, which translates into generating ad revenue from mobile devices like smartphones and tablets. For that, the company measures its mobile ad revenue and growth. Analysis of metrics such as period growth and ad pricing, where a positive trend would show continued period growth and strong pricing trends, should be used to determine the value to the overall company.

Usage metrics are also important indicators of site subscription and point towards potential advertising trends. But, it is the organic versus acquired growth that influences these metrics. If FB is growing through acquisitions (and they have a history of paying heftily for some), then the growth may actually be masking a problem with its core business. Another way to analyze the acquired growth is to compare the cost side. If costs are rising faster than revenues, that may be a red flag. When FB purchases a company, investors should be able to see the impact of that acquisition in revenues that should exceed expenses in the near- and long-term.

The Bottom Line

Prior to investing in any company, perhaps the most important discussion should focus on whether the company generates organic growth that justifies its valuation and whether acquired growth exceeds acquisition costs and becomes an organic revenue source. Slowing growth that is boosted by increasing investment spending should be considered a warning sign.