Earnings Quality: The Complete Framework for Spotting Low-Quality Earnings
Earnings quality measures how sustainable and real a company's profits are. High-quality earnings convert to cash; low-quality earnings are accounting tricks. This guide shows you exactly how to evaluate any company using our 3-metric framework with original data.
Earnings Quality: The Complete Framework for Spotting Low-Quality Earnings
Last Updated: January 2, 2026
Earnings quality measures how reliable and sustainable a company's reported profits are. High-quality earnings are backed by cash and use conservative accounting. Low-quality earnings look good on paper but don't translate to shareholder value.
TL;DR: The 3-Metric Quick Check
Most earnings quality problems can be spotted with three metrics:
- OCF/Net Income > 80% — Cash backs up reported earnings
- Free Cash Flow positive 3+ years running — Sustainable cash generation
- Stock-based compensation < 15% of revenue — Not excessive dilution
Red flags from our analysis:
- Tech sector average SBC: 22% of revenue (concerning)
- 95% of buyback programs are ineffective at reducing shares
- Coinbase: 0.10x cash conversion (only 10 cents of cash per earnings dollar)
Skip to: 3-Metric Framework | Company Examples | Red Flag Checklist
What is Earnings Quality?
Earnings quality answers a simple question: Are the profits real?
A company can report $1 billion in net income, but if that profit never converts to cash, shareholders don't benefit. Accounting rules allow companies to recognize revenue before cash is collected, defer expenses through capitalization, and inflate earnings through policy choices.
High-quality earnings:
- Convert to cash at or above a 1:1 ratio
- Use conservative accounting (recognize revenue late, expense costs early)
- Provide transparent disclosure
- Maintain sustainable compensation practices
Low-quality earnings:
- Show a gap between reported income and cash flow
- Use aggressive accounting (recognize revenue early, capitalize costs)
- Obscure true performance with one-time adjustments
- Dilute shareholders through excessive SBC
Why Earnings Quality Matters
Low-quality earnings precede many major stock declines. When accounting tricks run out, earnings "cliff"—often taking share prices down 30-50% in a single quarter. Identifying quality issues before the market does is one of the most reliable edges in investing.
The 3-Metric Earnings Quality Framework
Our analysis of hundreds of SEC filings revealed three metrics that catch most earnings quality problems:
Metric 1: OCF/Net Income Ratio
What it measures: How much of reported profit is backed by actual cash.
Formula:
OCF/NI Ratio = Operating Cash Flow (TTM) / Net Income (TTM)
Interpretation Thresholds:
| Rating | OCF/NI Range | Interpretation |
|---|---|---|
| Excellent | >1.2x | Cash exceeds reported earnings |
| Good | 1.0-1.2x | Earnings solidly backed by cash |
| Warning | 0.8-1.0x | Working capital consuming some cash |
| Red Flag | Below 0.5x | Potential earnings manipulation or distress |
Why it works: Accounting earnings can be manipulated. Cash flow cannot. When a company reports strong earnings but weak cash flow, something is wrong—either aggressive revenue recognition, inventory buildup, or receivables growing faster than sales.
Real examples from our data:
- AMD: 1.72x OCF/NI (excellent—cash exceeds reported earnings)
- Broadcom: 1.34x OCF/NI (good)
- NVIDIA: 0.84x OCF/NI (warning—working capital consuming cash)
- Intel: -0.49x OCF/NI (red flag—cash flow distress)
Metric 2: Free Cash Flow Consistency
What it measures: How reliably the company generates positive free cash flow.
Metric: Count positive FCF quarters out of the last 8.
Interpretation Thresholds:
| Rating | Quarters Positive | Interpretation |
|---|---|---|
| Excellent | 8/8 (100%) | Reliable cash generator through cycles |
| Good | 7/8 (87.5%) | Minor cyclicality, generally reliable |
| Warning | 5-6/8 (62-75%) | Inconsistent business model |
| Red Flag | Below 5/8 (under 62.5%) | Cash flow distress or highly cyclical |
Why it works: One exceptional quarter doesn't prove a business model. Eight consecutive positive quarters does. Consistency reveals whether cash generation is structural or temporary.
Real examples:
- NVIDIA: 8/8 positive quarters (excellent through AI boom and prior cycles)
- AMD: 8/8 positive quarters (excellent)
- Broadcom: 8/8 positive quarters (excellent)
- Intel: 1/8 positive quarters (red flag—severe cash flow distress)
Metric 3: Stock-Based Compensation Sustainability
What it measures: How much shareholder dilution funds employee compensation.
Formula:
SBC/Revenue = Stock-Based Compensation Expense / Total Revenue
Interpretation Thresholds:
| Rating | SBC/Revenue | Interpretation |
|---|---|---|
| Sustainable | Under 7% | Manageable dilution, typical for mature companies |
| Elevated | 7-15% | Acceptable for growth companies if declining |
| Concerning | 15-25% | High dilution eroding shareholder value |
| Extreme | >25% | Shareholders subsidizing employee compensation |
Why it works: SBC is a real cost to shareholders through dilution, even though it's a non-cash expense. Companies adding back SBC to report "adjusted" earnings are hiding real costs.
Real examples from our analysis:
- NVIDIA: 4% SBC/revenue (sustainable—improved from 10%)
- PayPal: 3.3% SBC/revenue (sustainable—declining YoY)
- Zscaler: 6.66% SBC/revenue (sustainable)
- Cloudflare: 19.56% SBC/revenue (concerning)
- CrowdStrike: 22.9% SBC/revenue (concerning)
- Snowflake: 41% SBC/revenue (extreme)
- Palantir: 24% SBC/revenue with 8.9% annual dilution (concerning)
Additional Earnings Quality Metrics
Beyond the 3-metric framework, these indicators catch specific quality issues:
Cash Conversion Cycle (CCC)
Measures days to convert inventory into cash:
CCC = Days Sales Outstanding + Days Inventory Outstanding - Days Payables Outstanding
Benchmarks for semiconductors:
- Under 50 days: Excellent (lean operations)
- 50-100 days: Acceptable
- 100-150 days: High (capital-intensive)
-
150 days: Concerning (working capital drag)
Examples:
- Broadcom: 37 days (excellent)
- NVIDIA: 81 days (acceptable)
- AMD: 159 days (concerning—high inventory cycle)
Capex/Depreciation Ratio
Reveals whether depreciation policies are conservative or aggressive:
Thresholds:
- 1.0-1.5x: Conservative (steady-state replacement)
- 1.5-2.0x: Normal for growth
- 2.0-2.5x: Warning (check depreciation policies)
-
2.5x sustained: Red flag (potential earnings inflation)
Real examples (hyperscalers):
- Amazon: 1.7x (most conservative)
- Microsoft: 2.1x (acceptable)
- Meta: 3.5x (concerning)
- Alphabet: 4.3x (worst in group)
Michael Burry estimated Big Tech will understate depreciation by $176 billion through 2028 by extending asset useful lives. Amazon is the only hyperscaler shortening depreciation schedules.
Buyback Effectiveness
Measures whether buybacks actually reduce shares:
Formula:
Effectiveness = Actual Share Reduction % / Expected Share Reduction %
Where Expected = Total Buybacks / Average Market Cap
Our analysis of $2.9 trillion in buybacks:
- 95% of programs are ineffective (under 50% effectiveness)
- Median company: 0% effectiveness (shares didn't decrease)
- Apple: 100% effectiveness ($648.5B reduced shares 17.8%)
- Microsoft: 23.6% effectiveness ($213B, only 2.7% reduction)
- JPMorgan: 0% ($121.3B, shares increased 6.6%)
The insight: Most buybacks just offset SBC dilution. They don't actually return capital to shareholders.
Earnings Quality by Sector: Real Examples
Cloud Security & Observability
| Company | EQ Score | OCF/NI | SBC/Rev | Verdict |
|---|---|---|---|---|
| Elastic (ESTC) | 7/10 | N/A | Low | Neutral accounting, sustainable SBC |
| Zscaler (ZS) | 7/10 | Good | 6.7% | Aggressive capitalization, good SBC |
| Datadog (DDOG) | 6/10 | Good | 6.4% | SBC growth (39%) outpacing revenue (28%) |
| Cloudflare (NET) | 4/10 | Good | 19.6% | High SBC + OFAC sanctions risk |
| CrowdStrike (CRWD) | 4/10 | Good | 22.9% | Highest SBC + July 19 litigation |
Full analysis: Cloud Security Earnings Quality Rankings →
Enterprise AI
| Company | EQ Score | Cash Conversion | SBC/Rev | Key Issue |
|---|---|---|---|---|
| Palantir (PLTR) | 6/10 | Positive | 14.6% | Neutral accounting, positive cash conversion |
| Snowflake (SNOW) | 4/10 | -0.47x | ~41% | Negative cash conversion, aggressive accounting |
The cash conversion gap is decisive: Palantir converts earnings to cash. Snowflake's -0.47x ratio means reported losses aren't even converting to cash at normal rates.
Full analysis: Enterprise AI Earnings Quality →
Fintech
| Company | EQ Score | Cash Conversion | SBC/Rev | Hidden Liability |
|---|---|---|---|---|
| PayPal (PYPL) | 8/10 | ~1.0x | 3.3% | $3.4B loan indemnification |
| Block (XYZ) | 6/10 | ~0.85x | Higher | $114M tax dispute + AG investigation |
| Coinbase (COIN) | 4/10 | 0.10x | N/A | $515.9B crypto custody exposure |
Coinbase's 0.10x cash conversion is extraordinary: Only 10 cents of cash for every dollar of reported earnings. Despite $3.2B net income, only $326M became free cash flow.
Full analysis: Fintech Earnings Quality →
Semiconductors
| Company | FCF | FCF Margin | OCF/NI | Verdict |
|---|---|---|---|---|
| NVIDIA | $77.3B | 41.3% | 0.84x | Strong with working capital caveat |
| Broadcom | $24.9B | 41.6% | 1.34x | Quality benchmark |
| AMD | $4.0B | 13.7% | 1.72x | Best cash conversion, capital-intensive |
| Intel | -$10.9B | -20.6% | -0.49x | Cash flow distress |
Full analysis: Cash Flow Quality Framework →
Earnings Quality Red Flag Checklist
Use this checklist to quickly identify potential earnings quality issues:
Cash Flow Red Flags
- OCF/NI ratio below 0.8x
- Negative free cash flow for 3+ consecutive quarters
- Cash conversion ratio below 0.5x
- Receivables growing faster than revenue
- Inventory buildups without clear demand drivers
Accounting Red Flags
- Capex/depreciation ratio above 2.5x sustained
- Large increases in capitalized software costs
- Goodwill representing >30% of assets
- Frequent "one-time" charges
- Revenue recognition policy changes
SBC Red Flags
- SBC above 15% of revenue
- SBC growth outpacing revenue growth
- Buyback program with 0% effectiveness
- Large unvested SBC liability (>3x annual expense)
- Dilution rate above 5% annually
Disclosure Red Flags
- Missing prior period comparisons
- Vague or undisclosed revenue recognition policies
- Incomplete amortization disclosure
- Material weakness in internal controls
- Frequent restatements or corrections
How to Screen for High-Quality Earnings
Step 1: Apply the 3-Metric Filter
| Metric | Threshold | Action |
|---|---|---|
| OCF/NI Ratio | >80% | Pass to Step 2 |
| FCF Consistency | 6/8+ quarters positive | Pass to Step 2 |
| SBC/Revenue | Under 15% (or under 20% if declining) | Pass to Step 2 |
Step 2: Check Sector-Specific Concerns
| Sector | Primary Concern | Additional Check |
|---|---|---|
| Technology | SBC dilution | Buyback effectiveness |
| Energy | Asset retirement obligations | Capex/depreciation |
| Healthcare | R&D capitalization | Pipeline write-offs |
| Financial | Loan loss reserves | Off-balance sheet exposure |
| Retail | Inventory quality | Same-store sales vs total |
Step 3: Review Filing Intelligence
Look for these specific items in SEC filings:
- Accounting policy changes (Note 1-2)
- Stock compensation footnotes (typically Note 10-15)
- Contingent liabilities and commitments
- Related party transactions
- Going concern language (if any)
Step 4: Verify Cash Conversion
Calculate: Free Cash Flow / Net Income
- Above 1.0x: Earnings are real
- 0.5x-1.0x: Monitor for deterioration
- Below 0.5x: Investigate the gap
Frequently Asked Questions
What is earnings quality and why does it matter?
Earnings quality measures how reliable and sustainable reported profits are. High-quality earnings convert to cash and use conservative accounting. Low-quality earnings may look good but don't create shareholder value. Poor earnings quality often precedes major stock declines.
What is a good OCF/NI ratio?
Above 1.0x is good—it means operating cash flow equals or exceeds reported net income. Above 1.2x is excellent (like AMD's 1.72x). Between 0.8x and 1.0x warrants monitoring. Below 0.5x is a red flag indicating earnings aren't converting to cash.
How does stock-based compensation affect earnings quality?
SBC dilutes shareholders even though it's a non-cash expense. Companies with SBC above 15% of revenue are using shareholder dilution to fund payroll. Snowflake's 41% SBC/revenue means shareholders subsidize nearly half the company's compensation costs.
What is cash conversion ratio?
Cash conversion measures how much of reported earnings converts to free cash flow. A 1.0x ratio means every dollar of earnings becomes a dollar of cash. Coinbase's 0.10x ratio means 90% of reported $3.2B earnings never materialized as cash.
What are common earnings quality red flags?
Key red flags include: OCF/NI below 0.8x, SBC above 15% of revenue, capex/depreciation above 2.5x for 8+ quarters, negative FCF for 3+ quarters, receivables growing faster than revenue, and aggressive capitalization policies.
How do I screen for high-quality earnings?
Use the 3-metric quick check: (1) OCF/NI above 80%, (2) FCF positive 3+ years, (3) SBC below 15% of revenue. Companies passing all three generally have high earnings quality.
Which sectors have the worst earnings quality?
Technology/SaaS often has the most concerns due to high SBC (22%+ average) and aggressive capitalization. Cloud security companies average 15-23% SBC/revenue. Growth SaaS like Snowflake reaches 41%.
What's the difference between GAAP and non-GAAP earnings quality?
GAAP includes all expenses; non-GAAP "adjusted" earnings often exclude SBC and one-time items. Large gaps between GAAP and non-GAAP (like tech adding back 20%+ SBC) indicate earnings may be overstated.
Deep Dive: Sector-by-Sector Analysis
For detailed company-by-company analysis, explore our Earnings Quality research library:
By Sector
| Sector | Analysis | Key Finding |
|---|---|---|
| Cloud Security | DDOG vs CRWD vs NET vs ZS vs ESTC | Elastic 7/10 leads; CrowdStrike 4/10 worst |
| Enterprise AI | Palantir vs Snowflake | Cash conversion is decisive metric |
| Fintech | PayPal vs Block vs Coinbase | PayPal 8/10 sets conservative benchmark |
| Semiconductors | Cash Flow Quality Framework | 3-metric framework with NVDA, AMD, INTC |
By Topic
| Topic | Analysis | Key Finding |
|---|---|---|
| SBC | Tech Stock Dilution | 99% of software FCF goes to SBC |
| Buybacks | The Buyback Illusion | 95% of $2.9T in buybacks ineffective |
| Depreciation | Amazon vs Hyperscalers | Amazon only one shortening depreciation |
Hub Page
- Earnings Quality Analysis Hub — Complete research library
Methodology
Data Sources
- Financial data: Extracted directly from SEC 10-Q and 10-K filings via EDGAR
- Earnings quality scores: 5-pass filing intelligence extraction
- SBC analysis: Stock compensation footnotes from quarterly filings
- Cash flow metrics: Operating and financing sections of cash flow statements
Calculation Details
OCF/NI Ratio:
OCF/NI = Operating Cash Flow (TTM) / Net Income (TTM)
Cash Conversion Ratio:
Cash Conversion = Free Cash Flow / Net Income
Buyback Effectiveness:
Effectiveness = Actual Share Reduction % / Expected Reduction %
Expected = Total Buybacks / Average Market Cap
5-Pass Filing Intelligence
Our earnings quality scores synthesize:
- Cash conversion analysis
- Accounting aggressiveness assessment
- SBC sustainability rating
- Hidden liability detection
- Disclosure quality review
Limitations
- Quarterly data may not capture annual patterns
- Sector-specific accounting (financials, REITs) requires modified frameworks
- Earnings quality scores are model-generated assessments
- One-time items can distort single-quarter metrics
- Forward-looking statements are management estimates
Disclaimer
This analysis is for educational and informational purposes only. It does not constitute investment advice, and you should not rely on it as such.
Important considerations:
- Past earnings quality does not guarantee future performance
- Earnings quality is one factor among many in investment decisions
- Accounting rules and interpretations evolve
- Always consult SEC filings directly for verification
- Consider consulting a qualified financial advisor
Data from MetricDuck analysis of SEC filings. Last updated January 2, 2026.
Explore More Earnings Quality Analysis
This definitive guide is part of our comprehensive Earnings Quality Hub, which covers cash flow verification, accounting red flags, and quality screening frameworks.
Related earnings quality research:
- Cash Flow Quality Framework — 3-metric verification for NVDA, AMD, INTC, AVGO
- Stock-Based Compensation Analysis — Which tech giants dilute shareholders most
- The Buyback Illusion — Why 95% of buybacks are ineffective
MetricDuck Research
SEC filing analysis and XBRL data extraction for fundamental investors