What Investors Actually Mean by “Quality of Earnings”

“Quality of Earnings” is one of the most frequently used—and most misunderstood—phrases in investing.

Founders often assume it refers to whether revenues are real, audited, or compliant with accounting standards. Investors, however, use the term very differently. To them, Quality of Earnings (QoE) is not about accounting correctness alone. It is about how durable, repeatable, and decision-useful earnings really are once the noise is stripped away.

This gap in understanding is one of the most common reasons why valuations get renegotiated late in a process.

Quality of Earnings Is About Sustainability, Not Accuracy

An income statement can be perfectly accurate and still have poor-quality earnings.

From an investor’s perspective, high-quality earnings are those that can reasonably be expected to persist—or grow—without heroic assumptions. The question being asked is not “Did you earn this?” but rather:

Will these earnings survive changes in customers, pricing, costs, capital structure, and macro conditions?

If the answer is unclear, earnings quality is weak, regardless of reported profitability.

The First Adjustment Investors Make: Normalization

The starting point of any QoE discussion is normalization. Investors want to understand what earnings look like under steady-state conditions, not what happened in a specific year.

Common normalization adjustments include:

• Founder salaries that are materially below or above market

• One-off consulting, legal, or restructuring costs

• Pandemic-era subsidies or relief programs

• Temporary cost deferrals or aggressive capitalization

• Non-recurring bonuses or incentive payouts

None of these are “wrong.” But until they are normalized, reported EBITDA is not decision-grade.

This is why many founders are surprised when investors “cut” EBITDA without disputing the financials themselves.

Revenue Quality Matters More Than Revenue Growth

Two companies can report identical revenue growth and still have vastly different earnings quality.

Investors look closely at:

1). Customer concentration
If a single customer accounts for 30–40% of revenue, earnings are fragile—even if margins look strong.

2). Contract structure
Recurring revenue under long-term contracts with clear renewal mechanics is valued very differently from project-based or cancellable revenue.

3). Pricing power
Revenue that depends on discounting, rebates, or ad hoc renegotiations is inherently lower quality.

4). Revenue recognition discipline
Aggressive upfront recognition or milestone accounting raises immediate red flags during diligence.

In practice, investors would rather accept slower growth with high revenue durability than rapid growth that cannot be defended under stress.

Cost Structure Tells the Real Story

High-quality earnings are not just about revenue. They are about how costs behave when conditions change.

Investors often examine:

Fixed vs variable costs
A cost base that flexes with demand is safer than one that is locked in. For instance, if a business has significant fixed operating costs embedded in their business model, due to high warehousing requirements or even due to significant capital hold-up in inventory, it is riskier during periods of slow business offtake.

Operational leverage
Margins that improve with scale indicate a scalable business model. Margins that deteriorate raise questions. This could largely be due to operating cost reductions at scale.

Deferred costs
Underinvestment in technology, compliance, or talent may inflate short-term earnings but erode long-term value.

When investors talk about “earnings quality,” they are often reacting to what is missing from the P&L, not what is visible.

Cash Conversion Is the Ultimate Test

At some point, every QoE discussion converges on cash.

Strong earnings that do not convert into cash—due to receivable build-up, inventory issues, or working capital strain—are inherently lower quality. Investors want to see alignment between:

a) EBITDA growth

b) Operating cash flow

c) Working capital discipline

A business that reports profits but constantly requires external financing to operate signals structural weakness, not strength.

Why Quality of Earnings Directly Impacts Valuation

Earnings quality is one of the most powerful—but least transparent—drivers of valuation multiples.

High-quality earnings justify:

• Higher multiples

• Lower perceived risk

• Greater tolerance for forward projections

• Cleaner deal structures

Low-quality earnings result in:

• Discounted multiples

• Escrows or earn-outs

• Deferred consideration

• More aggressive downside protection for investors

In many transactions, valuation gaps are not about optimism versus pessimism—they are about differing views on earnings quality.

The Founder Mistake: Defending the Numbers Instead of Improving Them

A common mistake founders make is defending reported EBITDA instead of proactively addressing quality concerns.

Investors rarely question arithmetic. They question assumptions, durability, and incentives.

Founders who acknowledge weaknesses, normalize transparently, and show how earnings quality improves over time are viewed as credible stewards of capital. Those who resist adjustments often trigger deeper skepticism.

How to Prepare for a Quality of Earnings Lens

If you are preparing for fundraising, an investor entry, or a strategic transaction, the right question to ask is not “Are our numbers correct?”

It is:
If an investor stripped this business down to its economic core, would they trust what remains?

At Epoch Ventures, we approach valuation and financial modeling with this lens embedded from the start. Not to reduce value—but to ensure it is defensible, credible, and aligned with how real capital is deployed.

Because in the end, quality of earnings is not an accounting concept. It is a trust concept.