The earnings ayatollahs are back in force and some readers are enquiring whether the Rule of 20 uses GAAP earnings or not.
It does not, and it should not.
GAAP earnings are useful when analysing individual companies. Some companies abuse the system and investors should do their work before investing. Many people will research the whole web before buying a toaster but will invest in a stock without first spending 30 minutes perusing the annual report, the 10-K and the notes to the financial statements looking for clues about management’s conservatism and/or integrity. Looking back over the years, one can quickly check if “non-recurring” or “one-time” charges actually recur more often then not, raising serious doubts on management’s competence and/or integrity. Always avoid investing in companies using very liberal or doubtful accounting practices. Most corporate executives are pretty smart; those who also feature dubious morality can be highly dangerous to your financial health.
When it comes to index earnings, I use “operating earnings” for the following reasons:
- companies included in the main indices are seasoned, widely followed and generally run by honest people.
- the main earnings aggregators are also serious companies which understand the game. Most will actually adjust the reported operating earnings to make sure they are representative of the company’s actual operating performance and coherent within the index and with history.
- The objective is to be objective, that is using numbers that reflect as closely as possible the true earnings power of companies composing the index. For example, a company may have to write-down an asset or restructure its organization, often incurring large one-time costs that reduce profits for that particular year. Blindly using reported earnings will likely distort the earnings potential of the on-going entity.
Asset write-downs or write-offs generally culminate during recessions when companies often need to streamline their operations or even simply bring an asset value down to its true value since, under GAAP, assets must be carried at the lesser of cost or value. Goodwill created in an acquisition must be periodically tested for impairment. Sharp economic downturns usually bring goodwill impairments which can seriously reduce an index GAAP earnings during the recession year but will often improve the continuing earnings potential. Blindly or dogmatically utilizing GAAP earnings will likely result in lost investment opportunities like was the case in 2009.
Here’s what I wrote on March 3, 2009 (S&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years):
Since the mid-1980’s companies have been showing 2 sets of earnings: “reported” GAAP earnings and “operating” earnings or GAAP earnings excluding non-operating profits and losses and write-offs. Companies which record “non-recurring” gains or losses or which book write-downs or write-offs in asset values in a given year also provide “operating” earnings so that investors get a “more accurate” picture of a corporation’s “true” profits from continuing operations and its realistic earnings power going forward.
The pros and cons of “operating” earnings are that:
- It makes sense for corporations to segregate from operating earnings those gains or losses which are deemed outside of the normal operations of a company (e.g. asset sales, discontinued operations). This is also useful to investors who can better appreciate the recurring profit generating capabilities of companies.
- Write-offs and write-downs are more debatable since they reflect a loss in value of certain specific assets which management or auditors deem inflated in a company’s books given present and expected circumstances. On the one hand, such losses in values reflect the inability of management to extract acceptable or appropriate returns from these assets at their current book values, justifying their inclusion in earnings. On the other hand, to the extent these write-offs or write-downs are one-time non-recurring events, excluding them from “operating” earnings provide a more accurate picture of the company’s earnings power under its new adjusted asset base.
- There is admittedly a degree of discretion for corporations to classify gains or losses as “recurring” or “non-recurring”. Some companies have used this discretion in such a way that they report “non-recurrings” so often that they become recurring non-recurrings.
Reported vs operating earnings has only been a big factor in market valuation in early 2000, when the tech bubble burst, and …now.
And now. The main culprit this time is the sharp drop in oil prices which has compelled producers to revalue their assets to reflect the lesser of cost or value which, for many, meant taking big write-downs. The stocks of oil producers have adjusted down to their new earnings power long before the accounting charges have been recorded. Large asset write-offs by energy companies do not change the earnings power of non-energy companies nor should they affect their valuations.
RBC Capital charts the ratio of write-offs to “pro-forma” (operating) earnings to reveal the magnitude of recent energy write-offs and the fact that, outside of energy, write-off trends remain within their normal range.
This chart plots operating EPS as a percent of “as reported” since 1988. The so-called conspiracy has not gotten worse:
Both GAAP and non-GAAP EPS of S&P 500 ex-Energy companies are expanding.