While the idea of clamping down on creative accounting is a good one, S&P's new category of 'core earnings' is likely to depress profits further
Corporate earnings come in all shapes and sizes and are coloured to appeal to specific constituencies.
During the stock market boom, companies adopted pro forma earnings, basically anything they wanted them to be, to portray financial results in the best possible light to boost the share price.
Over the years, companies have taken similar liberties with operating earnings, which conceptually are what an investor in any company wants to glean. Many so-called 'non-recurring expenses'' curiously recurred quarter after quarter.
'Operating earnings have been outperforming reported earnings for the last 20 years,'' says Bob Barbera, chief economist at Hoenig in Rye Brook, New York. 'If operating earnings were really getting at underlying profits, they would be a straight line with reported profits vacillating around them.'' Now comes Standard & Poor's with a new measure of 'core earnings'' to take some of the creativity out of corporate accounting.
Core earnings as defined by S&P reflect earnings generated from a company's principle, or core, business. Included in core earnings are the costs of granting stock options and pension fund costs; excluded are things like pension fund gains and merger and acquisition fees.
Already you can see the problems. By including pension-fund losses and excluding the gains, it puts a market outcome into the earnings numbers, and a lousy one at that.
According to S&P's new measure, earnings per share for the S&P 500 Index for the 12 months ended June were $18.48, and a price to earnings ratio of 48. That compares with reported earnings of $26.74 per share and a P/E of 33.5, according to Steve Wieting, senior economist for equities at Salomon Smith Barney.
The idea of standardising earnings so that companies can't report what they want to report makes sense. And the idea of trying to arrive at a core measure of operating profits, or what a company earns from current operations excluding one-time gains and losses unrelated to its main business, is a noble endeavour. It just so happens that S&P's timing stinks.
'Once again we're revising the methodology to make earnings look worse than under GAAP,'' or generally accepted accounting procedures, Wieting says. 'We're doing everything to divorce current earnings from economic performance.''
For example, by including pension fund costs at a time when defined benefit plans are staring at a gaping, underfunded hole 'is like sticking the worst bear market in a generation into earnings,'' Wieting says. It's bad enough that the stock market is already a proxy for the economy, the basis for consumer and business confidence and a one-stop-shopping guide to the future. S&P is now 'forcing the stock market to be the arbiter of earnings,'' Wieting says.
S&P's adoption of accounting for stock options at issuance, a method the experts can't agree on, introduces another problem. 'By including an ex-ante option expense, S&P is missing the big story of the late 1990s, which should be reflected in NIPA profits,'' Barbera says.
The Commerce Department compiles a quarterly measure of quarterly profits for the entire universe of US companies along with its report on gross domestic product. This measure strips out the gains or losses on inventories, which aren't related to current operations, and converts depreciation into economic terms.
The National Income and Product Accounts (NIPA) include an ex- post options expense: Companies incur the cost when an employee exercises his stock options and the company buys back shares to prevent dilution.
It was the exercise of stock options that depressed NIPA profits even as reported earnings rose through 2000 (NIPA profits peaked in 1997).
Exercising stock options has gone out of vogue as the options have gone out of the money after three consecutive years of stock market declines. So one huge expense has dropped out of the NIPAs. S&P's core measure of earnings 'won't capture the extent to which cash flow was used to buy back shares,'' Barbera says. 'To the extent that the compensation expense increase was options exercising, the collapse (in options exercising) will be an important part of margin improvement.''
With this depressant to NIPA profits removed, they should show an increase of more than 20% in the third quarter from a year ago, according to Jim Glassman, senior US economist at J.P. Morgan Chase. That compares with analysts' expectations for a 6.3% year-over-year increase in S&P 500 earnings in the third quarter, according to Thomson First Call. The First Call estimate implies a sequential decline in profits in the third quarter, which Glassman finds implausible.
'GDP was up, unit labour costs fell, productivity rose,'' Glassman says. 'Most likely, the growth went to profits.''
Barbera agrees. 'The consensus for third-quarter real GDP is something like 4 to 4.5% and 1.5% for prices,'' he says. 'That implies nominal third-quarter GDP of 5.5 to 6%, which puts year-over-year growth of the economy's top line at 4%.''
At the same time, wages and salaries grew about 2% in the past year, Barbera says. 'The largest cost for business is up 2%, and the top line is up 4%. Any appropriate measure of profits will be up meaningfully, say 20% year- over-year.''
Meaningful profits are not exactly what S&P core earnings are conveying. Besides, without any history, the series exists in a vacuum.
'It would be nice to see what profits did during the boom with option grants counted as an expense and pension fund gains excluded,'' Wieting says. Without history, S&P core earnings will appeal only to a constituency of depressives.
Bloomberg newsroom, New York
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