Behind the numbers: when it comes to earnings, look for quality, not just quantity.

AS WE HEAD INTO EARNINGS SEASON FOR THE SECOND quarter, make sure that you're focusing on what matters most. All too often investors fixate on how much a company is earning, rather than the actual quality of the earnings. Yet with so many companies missing estimates these days, the practice of measuring earnings quality can help you identify which companies are best positioned to make their projections.

Experts say that savvy investors look at a few additional performance measures, and doing so doesn't require a Ph.D. in quantitative analysis. Most of the telltale signs can be calculated by looking at the income statement, balance sheet, or annual report footnotes: items such as free cash flow, revenue growth, inventories, receivables, and research and development.

Examining variables like these will help you find companies with the best chances of repeating their earnings growth, says Maceo K. Sloan, chief investment officer of NCM Capital in Durham, North Carolina (No. 6 on the BE ASSET MANAGERS list with $2.9 billion in assets under management). "You are looking for companies you can depend on to do better than, or at least meet expectations quarter after quarter," Sloan says. "These are companies where earnings are coming from the operations, not from extraordinary events that may happen and are not necessarily going to be repeated."

Companies that make earnings targets by benefiting from a lower tax rate, or booking orders not yet fulfilled could mean trouble. Investors should always ask: "Are the earnings an honest assessment of the true economic picture of the company, or is it just smoke and mirrors?" says Dirk van Dijk, director of research at Zacks Investment Research Inc. in Chicago.

The ability to find quality earnings comes in handy during today's uncertain times: Many sectors of the market have been hit hard in recent months, and it's difficult to get a handle on where things are headed. Though the S&P 500 index fell nearly 10% in the first quarter, by mid-May it was down just 3% for the yeas It's in a tough economic environment that executives might be inclined to look for ways to make earnings better than they really are--legally, of course.

"What we have seen in downturns is companies will try to keep their earnings up and will use any devices they can," says Victor Germack president of Rate Financials, a New York-based firm that rates corporate earnings quality. "There is that temptation."

Start with cash flow. The metrics you should evaluate depend on the type of company you are researching, but there are a few helpful signposts. Peter Bates, an analyst at T. Rowe Price, an investment management firm based in Baltimore, likes measuring a company's free cash flow to net income. Free cash flow is the cash flow of a company less its capital expenditures. Simply put, it is the amount of cash a company has available after it has paid all of its expenses--including dividends. Free cash flow and net income should be in the same neighborhood, Bates says. "If earnings quality is legitimate, the two should be in line."

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Bates adds that good companies actually should be generating a little bit more free cash flow than net income. For good companies, it's in the ballpark of 120%; average companies tend to run about 100%; for poorly run outfits it's 80%. If the ratio is below 100%, then it's likely that something is awry, he says. "You've got to ask yourself what's going on if free cash flow is a lot less than net income," Bates says. "Once you learn that it is, then you've got to look at what's causing it."

For example, a company's inventory might be rising. That's why Bates likes to look at annual figures, particularly because some industries, such as retail, do the lion's share of their business in one quarter.

In Bates' coverage of industrials, one company with a strong history of free cash flow to net income includes Danaher Corp. (DHR), a maker of professional, medical, industrial, and consumer products. The company has had a ratio around 120% for 15 years running. Another example: Republic Services Inc. (RSG), a waste management company. Its free cash flow to net income is consistently around 110%.

A similar barometer is cash flow yield, a measure of free cash flow per share. It's one of the metrics preferred by Robert Stimpson, a portfolio manager at Akron, Ohio-based Oak Associates, which has $1.2 billion in assets under management. To calculate cash flow yield, divide free cash flow by the current stock price, then compare this figure with those of competitors. "There is a comfort factor knowing that a company generates a lot of cash rather than one that relies on booking accounting-based earnings," Stimpson says. "Cash flow yield is kind of like an earnings yield, but it's a harder number to manipulate. Earnings can be affected by noncash items or accounting methodology, whereas cash flow is a better proxy for cash being generated by a business."

Another helpful variable is profit margin, says Kurt W. Brunner, an equity portfolio manager at the Swarthmore Group based in Philadelphia. Are margins improving because of a new product cycle or better pricing? Are costs going down because of falling component prices? Improvements stemming from factors along those lines are always positive, Brunner says. He also looks at backlog--the accumulation of orders that haven't been fulfilled yet. For instance, he says that Goodrich Corp. (GR), a commercial aircraft supplier, has a healthy backlog of orders because of the high demand for new planes.

Investors can also look at growth of receivables--this should be in line with revenue growth, van Dijk says. If receivables are growing faster, then has the company set aside a greater portion to allow for losses? "If receivables doubled when revenues have increased 20%, that is a blinking red light," he says.

With technology companies, van Dijk also looks for investment in research and development to keep pace with revenues. "It should be a constant or increasing part of revenues," he says. "By cutting off R&D funding, you are eliminating future earnings potential." Companies dependent on advertising might also slash expenditures in order to make earnings look better. While that won't hurt in the short run. it could open the door for other competitors to gain ground, he warns.

Investors should also be wary of companies with so-called defined benefit plans, van Dijk adds. These are old-style pension plans in which a corporation pays into a general retirement fired for its employees. The danger is these plans might be under-funded, despite a company's assertions to the contrary. A critical factor is the assumptions a company makes in order to forecast returns for the plan. These figures are usually buried in the footnotes of annual reports or 10-K filings with the Securities and Exchange Commission. If the projected returns fall short, the company will have to pour money into the plan just to meet liabilities at a future date--eroding earnings.

Some companies have sizable liabilities to future retirees, and it is critical to pay attention to what the assumed return on investment is for the fired. For a fund that has a 60% equity and 40% fixed income mix, an assumption of an 8% annual return would call for "heroic" performance of the portfolio, van Dijk says. "Most companies have an assumption around 8%--and that is too high," he warns. Companies that are also increasing their projections should be looked at extremely skeptically.

So as companies meet expectations, buyer beware--pay attention to earnings quality, Sloan warns. It's quality that will determine how your stock is going to do over the long haul.

8 Ways to Measure Earnings Quality What You Should Look For

1 Free Cash Flow/Net Income A company with a ratio around 120% translates into a well-run company; 100% means average; 80% means trouble.

2 Free Cash Flow/Stock Price This is similar to an earnings yield, but it is harder to manipulate. Compare this ratio with those of competitors.

3 Profit Margins Are they growing year after year?

4 Backlog Growing backlog often means high demand for a company's product.

5 Receivables revenues are growing much faster than receivables, check to see if the company has made appropriate allowances for bad debt.

6 R&D a company's R&D spending isn't keeping pace with revenue growth, be sure to find out the rationale.

7 Marketing company cut back on advertising to meet earnings projections?

8 Pension Plans What kind of assumptions does the company make for returns on the plan's investments?