Explain what is meant by sustainable (persistent) earnings
The idea
Sustainable, or persistent, earnings are those likely to continue. Persistence can be measured by regressing next year's earnings on this year's, where a coefficient close to 1 indicates highly persistent earnings and a low coefficient indicates earnings that fade: E1 = α + β × E0. Because the cash component tends to persist more than the accrual component, the regression can be split, with β1 greater than β2: E1 = α + β1 × cash flow + β2 × accruals. Earnings made largely of accruals therefore deserve a lower multiple. Recurring operating profit from core activities is more persistent than gains on disposals. The trap is valuing all components of profit at the same multiple.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Evaluating Quality of Financial Reports
- Show how a conceptual framework is used to judge how reliable and useful a company's financial reporting is
- Explain problems that can undermine the quality of financial reports
- Explain the process for judging how good a company's financial reports are
- Judge how good a company's financial reports are
- Explain the signs that indicate earnings quality
- Explain why earnings revert to the mean and how accruals change how quickly they do so
- Judge the quality of a company's earnings
- Judge the quality of a company's cash flows
- Explain the signs that indicate balance sheet quality
- Judge the quality of a company's balance sheet
- Explain the signs that indicate cash flow quality
- Set out where information about risk can be found