Earning quality of Chinese IPOs

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What is earning quality?
As a new investor, I used to look at earning of a company heavily. I think earning is also the driver of a stock price in the wall street. If a company issues earning report which beats the street, and offers upbeat outlook for next quarter (or next year), the street will bid up the stock, vice versa. But there is two problems when we solely focus on earnings. For one, growth company, especially IPOs like Google and Salesforce in 2004, and Baidu in 2005 may not be profitable. Or if they are profitable, they don’t make too much monney thus its PE ratio is usually high.

More importantly, from my own experience in last year and reading for CFA, I found not all earnings are equal. In other words, if GE and a 2007 Chinese ADR IPO both made 50 cents in a quarter, I would bet GE’s 50 cents is much more close to the reality. This hypothesis is obviously confirmed by Barron’s in last weekend, as it pointed out the earning quality problem for some Chinese IPOs last year: LDK, Nepstar, Yingli (YGE), GA. I think to a lessor extent, Longtop Financials (LFT) has a similar problem. Barron’s has pointed out a few things to pay attention such as the inventories accounting problems in LDK.

Show me the money
Cash flow statement tells more real stories for the companies. The problem is, Chinese ADR companies don’t need to file 10-Q as required by the US companies. But they got to file the annual report. Anyway by looking at cash flow statement in the annual report, with the following questions:

1) Is the operating income close to cash flow generated by operation?
2) Is cash mainly generated by operation or financing, or investing? I bet investing is a very important souce of cash for companyies like LFC.
3) Check inventory changes for manufacturing or merchandising companies, to see if they are significant.

Bottom line, with the flood of Chinese IPOs listed in NYSE last year (to a lessor extent to Nasdaq), I have not found one compelling IPO to buy into at this time.

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