Friday, April 24, 2009

Operating Earnings v As Reported Earnings

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I found this piece on FT.com, and it touches on something that has bugged me for most of the decade... all this GAAP v non GAAP reporting. I thought this was a situation that had been going on for decades but apparently, it has really blossomed just in the 2000s (when financial innovation rules). A quick and dirty is companies now report a lot of what they call "one off" adjustments, and then the analysts and the company wink at each other, and say it doesn't count as an expense because it does not re-occur. My favorite is executive compensation via stock option; technology companies circa late 90s (and even now) were/are huge on this. So for example we made $30M this quarter, and have 30M shares = so $1.00 EPS. But we gave $20M to executives via stock option (wink wink) ... so factually we only returned $10M to shareholders i.e. $0.33 EPS. And the other $0.66 EPS went to our hard working folks at the top.

In the old school way of doing things this company would show earnings of $0.33 since when you give money away it still "counts" (in the old days), but in the current system it's $1.00 EPS because the executive compensation is "extraordinary" "one time in nature". Even though it happens every quarter. But it is not part of operations, hence should not count against the company. I see a lot of companies throw "restructuring" or "write offs" (that they do every quarter) and a host of other things into their P&Ls - then they report the non GAAP number and we all cheer.

So anytime you hear about the PE ratio of the market being this or that, I truly don't believe we are using apples to oranges to the 1980s, 1970s, or before. We now have the wink wink PE multiple - and in fact it would showcase how expensive the market has been. But as long as we all believe in the same fantasy accounting it works - sort of like a Ponzi scheme.

Now I do not know if in these charts they use my favorite - executive compensation - but it splits out write offs and restructurings (which are included in "as reported earnings", but not in "operating earnings") And "operating earnings" are what we all use now in our estimates, under the guise of all the other things that hit these companies are "1x in nature" and hence we should not use them in our multiples... even though many companies now use the same "one off" adjustments every quarter as a place to funnel expenses.

The timing for this analysis by BNP Paribas was due to the thesis that the market is indeed cheap... it's an interesting view that will not be part of the mainstream. And please note: non of this matters in the current environment - its just for academic information.

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In a note issued late on Thursday, the credit analysts at BNP Paribas argued that “despite a close to 5o per cent drop in equity valuations, equities look not only rich but are significantly mispriced and are a bubble waiting to be pricked.”

Here are some highlights, which include quite a lot of snickering at the “unfathomable” bullishness of equity types (emphasis ours):

Over the past equity bubble decade, it has become fashionable for equity analysts to concentrate on Operating earnings as opposed to As Reported earnings, which factor in write-offs and restructuring charges (Charts 1 and 2). While the difference between the two measures was insignificant until the internet bubble, that difference has grown significantly to the extent that operating earnings look like numbers plucked out of thin air with little resemblance to economic reality.

As credit analysts, we are taught that, for a given revenue base, rising costs lower profits, raise leverage and lower creditworthiness. How equity analysts can ignore this fundamental credit analysis is unfathomable to us.

BNP Paribas chart of S&P 500 EPS.pngBNP Paribas chart of differential between operating as and reported as EPS for S&P 500.png

Using current valuations, if one were to calculate the P/E multiple on 2009 earnings, one lands up with 14x using operating earnings and 30x using as reported earnings. We will leave investors to make their own judgement but P/E multiples of 30x certainly scream bubble to us.



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