Accurate Earnings Measurements During Times of Uncertain Earnings
It is no secret that investors are increasingly being required to take a more critical look at corporate financial statements. As stories of corporate fraud proliferate, casual and professional investors alike have begun to take new precautions in educating themselves about the validity of publicly released data. Getting up the curve has been costly, however, as many are only now beginning to conduct the fundamental investigation that has for a long time been taken for granted.
A recently published Merrill Lynch report on earnings quality entitled Towards a 360° View of Reality addresses the investor's perception of a widening gap between corporate financial reporting and "reality." The report cites a study by the ML Global Strategy Group in which a group of fund managers was surveyed regarding their opinions on the quality of earnings present in the financial statements of U.S. companies versus those of their peers in other global markets. In March 2002, 43 percent of managers believed U.S. equities were the most reliable, while only 9 percent thought that U.S. equities were the worst. In July 2002, the same survey among the same group revealed a monumental shift in opinion, with a mere 19 percent retaining their confidence in U.S. numbers. The percentage feeling U.S. companies had the worst quality of earnings skyrocketed to 34 percent.
In the current environment, investors, lenders and others who rely on reported financial information are showing a new skepticism about the quality of earnings on many levels. Stories about major U.S. corporations manipulating earnings have been in the headlines for much of the past year. In this article, we do not attempt to delve into the multitude of issues behind this phenomenon, but rather we focus on the subject of different earnings metrics and how each can present a different level of "quality of earnings." We address Earnings Per Share (EPS) under generally accepted accounting principles (GAAP) as well as two common alternative measures of performance, pro-forma EPS and cash EPS, and discuss the evolving roles of these metrics in today's reporting environment.
GAAP EPS is considered by many to be the most meaningful data point among the various earnings statistics, as it is the byproduct of many years of accounting study and rulemaking by bodies of independent standards boards. EPS figures are intended by design to provide an accurate proxy for measuring an enterprise's results and progress over multiple reporting periods, providing a standardized, highly documented and widely known basis for comparison.
In short, GAAP EPS captures the net per share economic production of a company's operations over a fixed period of time after all costs arising from the operation of the business have been deducted from the revenue it has produced. The actual calculation of EPS is fairly straightforward from a macro perspective, typically beginning with revenue, then subtracting cost of goods, operating expenses, depreciation, amortization, interest and taxes to come up with net income (numerator). Net income is then divided by the total shares outstanding (denominator) to determine the EPS figure.
Total shares outstanding is normally reported for both primary and diluted shares. Primary shares represent those shares that are currently issued and outstanding. The diluted shares amount represents a more conservative position, as it encompasses all "common stock equivalents," including warrants, convertible debt, in-the-money options and other instruments that would dilute primary ownership in a liquidation scenario. More often than not, investors focus on the diluted number, as the existence of common stock equivalents will have a real impact on per-share values.
The extent to which EPS is relied upon to determine a company's relative performance is no more evident than in the emphasis placed on those numbers by corporations at the end of each reporting period. Additionally, the direct and immediate reaction of the financial markets to EPS announcements highlights the underlying assumption of integrity placed in such figures by the investing public.
The strength of EPS methodology lies in its ability to produce a "general purpose" set of financial data. However, while EPS does effectively standardize, it does nothing to normalize, which some would argue is the very reason its "quality of earnings" value is lower. This perceived weakness has given rise to myriad alternative reporting methods, all of which intend to communicate a company's relative status more meaningfully.
Perhaps the most common alternative reporting metric, pro-forma EPS typically begins with GAAP EPS and adds back the net effects of M&A fees, restructuring charges, asset impairments or other expenses considered atypical or non-recurring. Other common pro-forma addbacks include in-process R&D expenditures, goodwill amortization charges, stock compensation expenses and costs associated with the capitalization of intangible assets. The term "pro-forma" indicates that assumptions or hypothetical conditions have been built into a certain data set when calculating EPS. The methodology essentially attempts to isolate a company's results in a "normal" operating environment.
A pro-forma number could be valuable to an investor in a case where a company took a one-time charge relating to a specific, definable event. The case could be made that the pro-forma evaluation in this situation more accurately reflects the company's long-term prospects relative to GAAP-based analysis. This conclusion would obviously depend on the likelihood that an event of similar magnitude would not happen on a regular basis. Many companies, particularly those in financial distress, have made a habit of identifying "one-time charges" quarter after quarter, clearly signaling that continued adjustments for such items may not be appropriate.
The obvious concern about any pro-forma methodology is that it could potentially hide, obscure or inflate a GAAP EPS number given that it is not bound by any specific accounting standards. Indeed, reporting entities have substantial leeway in the presentation of pro-forma results. They do, however, face scrutiny and potential enforcement actions by the SEC, stock exchanges or others if releasing misleading press or financial statements, or failing to adhere to guidelines requiring full and fair disclosure.
This is somewhat encouraging for investors in search of "quality earnings," but due to the subjectivity of pro-forma figures, this metric requires more scrutiny than GAAP-based results.
In The FASB Report dated Feb. 28, 2002, the author notes that "the widening gap between pro-forma and U.S. GAAP EPS relates to a dramatic increase in the magnitude and frequency of expenses that are being excluded from pro-forma earnings." Increased use of non-recurring classifications through pro-forma evaluation seems to have desensitized many investors, who have adopted somewhat of an "out-of-sight, out-of-mind" mentality as it relates to the real effects of unusual items. While perhaps "one-time" or unusual in nature, many of such items have a true economic cost to the business enterprise, and such cost cannot be overlooked in assessing the value of a business or its stock.
A recent study by University of Michigan researchers concluded that there is a strong degree of correlation between the level of companies' excluded expenses in their pro-forma presentations and their actual cash flows during future periods. Additionally, the study found a significant difference between the stock returns of firms with high vs. low amounts of excluded expenses, with stock returns up to 45 percent lower for firms with relatively large exclusions, compared with those firms with small exclusions. The primary implication of this research is that the nature of excluded expenses is such that they truly impact on cash flows and value. One might also infer that companies that underperform in the market are more likely to attribute negative aspects of performance to "one-time charges" and other excluded expenses.
With all of the concern about pro-forma presentations, should they simply be ignored? We believe the answer is no, but that they should not be used as the primary measuring stick of performance. Any analysis of pro-forma operating results should be accompanied by other analyses, and it is critical to understand the true nature of the pro-forma adjustments when making the evaluation.
A second alternative metric, cash EPS, is typically calculated as some form of operating cash flow on a per-share basis, and attempts to provide a per-share operating proxy that most accurately reflects the true net amount of cash flowing into a company during a reporting period.
One of the most common iterations of the metric begins with GAAP EPS and adds back the tax-effected impact of non-cash goodwill and intangible amortization costs. Other versions add back tax-effected, non-recurring charges as well.
Widespread use of cash EPS began in the mid to late 1990s as companies increasingly sought to grow by acquisition and to enhance their global presence, driving M&A activity to all-time highs. The huge amounts of goodwill associated with the acquisitions resulted in a substantial hit to earnings for many companies, especially the fabled "new economy" darlings that had acquired competitors operating from very limited asset bases.
Cash EPS helped to alleviate some of the pain that came as a result of using purchase accounting and was thought by some to provide a more relevant basis for evaluation. Proponents of cash EPS supported their position by arguing that the recording of intangible assets did not affect the amount of cash flowing into and out of a company, and the subsequent deduction of amortization unnecessarily increased discrepancies between operating cash flow and GAAP net income.
However, with the final implementation of FAS 141 and 142 in 2001, cash EPS became substantially less of a long-term issue as the periodic amortization of acquisition goodwill and pooling accounting were both eliminated. Cash EPS figures are still seen in financial reports today, but are typically applied on a pro-forma basis to pre-FASB 141/142 figures when presented against current results.
Should cash EPS be considered an appropriate measure of a company's performance? Again, like pro-forma EPS, we believe that it is one measure that should be considered, but not in a vacuum. Investors are interested in a company's net income, but an analysis that does not look at cash flow and other measures would be incomplete.
In the search for quality earnings, one thing that is encouraging to the investing community is the sheer quantity of information that is available for evaluation. The high level of disclosure required in the United States is exactly what enables us to take our own, customized measurements of corporate success. While the challenge may seem daunting to some, not having any information at all would no doubt be much worse.
Given the recent problems with financial reporting, it is now more important than ever for the investor to fully appreciate the differences between results reported under different methodologies. When non-GAAP information is provided, the motivation of management should be considered, and alternative measures should be evaluated. Metrics such as EPS, pro-forma EPS and cash EPS should be assessed, and reliance shouldn't be placed on a single measure, as each has its own strengths and weaknesses. A much more inclusive evaluation of quantitative and qualitative metrics alike will provide the best interpretation of value and help in the evaluation of quality of earnings.