Quality of earnings as an investment indicator : a literature review.

Abstract

This paper examines the characteristics of earnings quality, reviews the literature that assesses whether earnings quality does in fact affect market valuations and evaluates whether trading strategies based on this knowledge yield abnormal positive returns. This paper looks at why earnings quality should be an important consideration in evaluation [of] a firm, then investigates research on the accounting effect on valuations, covering the accrual effect, the general growth effect and the value-glamour effect. Thereafter, other factors that can influence earnings quality are documented, from earnings manipulation to the effects of external factors on quality of earnings. The concept and measurement of economic profits are also examined. Lastly, trading strategies based on earnings quality are investigated to see if abnormal profits can be earned from such strategies.