Analyst Spotlight Archive

Analyst Spotlight: Bryan Keller

Many investors probably don’t read the quarterly and annual reports released by the fund managers of the mutual funds they own. And I’m going to venture a guess that most – if not all – never read through the quarterly earnings releases from the individual stocks that they own, either.

Why bother? All one needs to do is simply venture to any one of the financial websites out there (Yahoo! Finance, Google Finance, etc.), type in the ticker of the company in query, and pull up the earnings “analysis” provided.

Better yet, for the widely followed companies (such as Microsoft, General Electric, Intel, etc.), most news outlets will lead their business section with the earnings releases of the aforementioned companies, usually providing a bland and oversimplified summary of the, well, bland and oversimplified press release they read to obtain the original information.

Though we all may not have time to dive into the 10-Q’s, 10-K’s and annual reports of all the stocks in our portfolios, it is still a healthy exercise to educate one’s self on a few basic items to prevent yourself from being caught in the media’s hype, or suffer the consequence of making a poor decision based on it.

Earnings Actually Come In Different “Flavors”
While a company’s earnings may seem like a simple number to calculate, investors face a lot of complicating factors and confusion about the right way to look at the figures. In fact, back in May 2001, Standard & Poor’s issued a report after “many members of the investment community expressed concern that earnings reports are becoming harder to understand, more difficult to compare across companies, and less useful to analysts and investors,” in an attempt to standardize and provide consistency to corporate earnings measures.

S&P consulted with accountants, portfolio managers, corporate executives and academic researchers, to build consensus for a proper earnings definition and developed three “general measures” of earnings:

• As Reported Earnings
  This is the broadest measure of corporate performance of the three considered. Reported earnings include all charges except those related to discontinued operations, the impact of cumulative accounting changes, and extraordinary items. This measure has been used for decades, and is the traditional earnings measure for the S&P. Another name for this measure is “GAAP” Earnings, which refers to the fact that this earnings measure is produced in accordance with Generally Accepted Accounting Principals.
  
  
• Operating Earnings
  This measure focuses on the earnings from a company’s principal operations, with the goal of making the numbers comparable across different time periods. This measure (some times referred to as “Adjusted Earnings”) attempts to show a clearer picture of the trend in company earnings by removing one-time or “non-recurring” items from As Reported Earnings. Despite the lack of any generally accepted definition, as with As Reported or GAAP Earnings, Operating Earnings are increasingly popular in corporate reports.
  
  
• Pro-Forma Earnings
  Originally, the use of the term pro forma meant a special analysis of a major change, such as a merger, where adjustments were made for an “as if” review. In such cases, pro forma measures are very useful. However, the specific items being considered in an “as if” review must be clear. In some recent cases, “as if” has come to mean “as if the company didn’t have to cover proper expenses.” In the most extreme cases, pro forma is nicknamed EBBS, or “earnings before bad stuff.”

And in a subsequent report, S&P provide this definition on yet another earnings definition, which they now use as their preferred measure:

• Core Earnings
  Core Earnings measure the earnings power of a company’s business. It represents the difference between the revenue of a company’s principal, or core, business and the costs and expenses associated with deriving that revenue. A simple example would be a chain of retail stores. The core business is running stores. Look at the revenues and the expenses from those stores and you can find core earnings. While many retail chains may buy and sell real estate, it is not their main business. Neither is running a pension fund, or many other things that such a company may do.

Which Earnings Definition Is Best For Investors?
Unfortunately, there is no simple answer to that question. As Reported and Operating Earnings are the most commonly used by corporations when releasing their earnings reports, but each has its own problems. For example, As Reported earnings may seem the best because they at least follow an accepted set of “rules.” But a look at the chart below comparing the two measures shows that As Reported Earnings have been far more volatile overtime than Operating Earnings although they show the same major trend.

Some of this can be explained by the fact that As Reported Earnings include some things that are not part of the regular operating business of the company, such as the costs to fight a lawsuit, which are those “non-recurring” expenses that Operating Earnings excludes. But notice, specifically, the sharp decline in As Reported earnings just after December 2000. While part of that was driven by the recessionary environment, once the economy turned downward companies began writing off everything they could think of, knowing that the market was going to punish their stock price in the bear market anyway. With these charges out of the way, they were set up to have an easier time growing earnings later when the market might be in a more “rewarding” state of mind.

So are the smoother Operating Earnings therefore the better guide? Not necessarily. That smoothness is in itself a bit suspect. Because there are no established accounting guidelines on this method of calculating earnings, some companies were playing fast and loose with the definition of non-recurring items. In many cases, particularly during the go-go tech/internet boom, large “non-recurring” items to be excluded were a very regular occurrence!

However, the good news for investors is that as the Enron and WorldCom debacles took center stage, and as our nation’s lawmakers produced the Sarbanes-Oxley Act in reaction to the corporate malfeasance, companies quickly took notice and shaped up their earnings reports. The following graph, which compares the differences in methods of reporting earnings since March of 2001 (including the newer Core Earnings), shows that since the first quarter of 2003, all three measures have been yielded quite similar figures.

While it’s good to see less variance in the earnings reports, we always need to be aware of the motivations of the corporate executives who report these numbers. Today, an increasingly important part of (and in many cases the lion’s share of) senior executives’ compensation is in stock options. The thinking is that by awarding executives options, as opposed to salaries or bonuses, their interests are more aligned with the interests of all the company’s shareholders’ – a higher stock price. And while a number of factors affect stock prices, earnings are of course key. So executives have a powerful incentive to “manage” earnings – whatever form they may take.

Did you ever marvel at how many times a company announces earnings that either exactly matches analysts’ estimates – or beat them by 1 penny! Well, according to a 1999 study of thousands of corporate earnings reports by Richard Zeckhauser, a professor of political economy at Harvard University’s John F. Kennedy School of Government, and coauthors François Degeorge and Jayendu Patel, you are right to marvel, because they found that the frequency of their occurrence is far higher (and conversely, the occurrence of misses by 1 penny far lower) than a random statistical distribution would predict. In other words, the statistical evidence strongly suggests many if not most companies are “managing” their earnings to expectations.

So while earnings reports may be a better guide to the real condition of a company today – they are far from perfect and still require a thorough overview. But it is nice to know that perhaps now we can spend less time figuring out which type of earnings to follow, and more time dissecting the actual companies and the factors that drive those earnings.

And, if still after reading this, you remain utterly lost and confused about the basics of corporate earnings – have no fear! A recent Wall Street Journal article disclosed that accounting-rule makers are looking to possibly eliminate what we know today as “net profit” in exchange for something else, and noted that, “Pretty soon the bottom line may not be, well, the bottom line.”

-- Bryan Keller