DEFINING EARNINGS QUALITY

To develop a technique for assessing earnings quality, I first had to understand what accounting would look like in a “perfect” world. In my view, the way to think of a company is as a portfolio of investment projects. If I, as a company manager, knew the future cash flows of these investment projects, I could compute the internal rate of return (IRR). Rather than discounting the cash flows at an appropriate discount rate, I could estimate the implied rate of return based on the investment required in these projects and the future cash flows they will pay out. In my perfect accounting system, I would then set book value equal to invested capital and the accounting rate of return would equal the IRR.

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