Investors Diverge on How Much Companies Earn: Taking Stock
By Robert Dieterich
quote.bloomberg.com
New York, Oct. 25 (Bloomberg) -- The companies in the Standard & Poor's 500 Index collectively earned $44.93 a share in the 12 months ended in June. Or they earned $18.48 per share. Or something in between.
The higher number is compiled by Thomson First Call and reflects operating earnings, which exclude most revenue and expenses unrelated to a company's main business. The lower is a ``core earnings'' figure, published yesterday by Standard & Poor's, which figures all costs, including pensions and options.
The differences stem from questions over how to address pension fund liabilities, employee stock option costs and one-time expenses such as employee severance. As investors try to decide whether U.S. stocks are cheap after a bear market of more than 2 1/2 years, they can't agree on the basic question of what companies earn.
``How can anyone be asked to invest in this market if you don't even know where you're starting,'' said Brett Gallagher, who helps oversee close to $4 billion for Julius Baer Investment Management. ``The key to investment worth is earnings.''
Disagreement about the earnings of S&P 500 companies of 5 percent or 10 percent would be manageable, Gallagher said. When one number is more than twice another, he said, ``how do you even begin?''
The net income based on generally accepted accounting rules that companies reported in government filings falls somewhere in between at $26.74 per share.
Index Valuation
Investors compare per-share earnings with the value of a stock index to help judge whether shares are expensive or cheap. When the S&P 500 dropped to a five-year low earlier this month, for example, many investors said it looked attractive on a price- earnings basis.
At the low, the index was valued at about 17 times First Call's tally of earnings for the prior 12 months. It traded at less than 15 times the operating earnings Wall Street analysts are forecasting for the coming year, which First Call also tracks.
The index traded for as much as 30 times forecast earnings in 2000 when stocks were near their all-time highs.
Others pointed out that the S&P 500 still was trading at nearly 30 times reported earnings. According to Standard & Poor's, the historical average using this earnings measure is 17 times.
While the index could be considered even more expensive based on the $18.48 core earnings number from S&P, most investors say that argument is moot because of the lack of historical data.
S&P plans to figure core earnings for the S&P 500 going back five years.
``If people intend on using that as the standard, a good study would then be the long-term core earnings and averages that go back as far as we can,'' said Matt Brown, a money manager at Wilmington Trust Co., which oversees $18 billion.
Do-It-Yourself
Gallagher doesn't accept any of these numbers and has developed three different measures.
Using average historical profit margins and the U.S. gross domestic product, he calculates total earnings for all U.S. companies and then adjusts that to get $34.76 in per-share profit for the S&P 500.
He also looks at the historical growth trend for reported earnings and extends that into the future, arriving at an estimate of about $44 a share for the S&P 500. And he adjusts that figure to eliminate pension fund gains and add in option expenses, to arrive at $39 a share.
These earnings figures point to a fair value for the S&P 500 in a range of 650 to 750, he said. That suggests the index, which closed yesterday at 882.50, could lose a quarter of its value.
Cliff Asness, who oversees $3.5 billion at AQR Capital Management, a New York-based hedge fund, said he uses a trailing 10-year average of the reported earnings for the S&P 500. That gets you $38 a share, he said. On that basis, ``we're currently at about 23 times earnings for the index,'' said Asness. He said it's ``hailing distance'' from fair value, which he reckons is about 20 times the 10-year average.
Shortcoming
Core earnings fail to provide a useful new profits benchmark because of the way Standard & Poor's accounted for pension expenses, Gallagher said.
The goal, according to Howard Silverblatt, an S&P editor who worked on the project, was to reflect all the costs and liabilities of maintaining a pension fund. That item ended up being the biggest part of the difference between reported earnings and core earnings.
The S&P earnings number includes a $2.05 adjustment that subtracts the pension fund investment gains that some companies add to net income.
It also has a $4.50 reduction for financing costs. While the Standard & Poor's method would offset this cost with investment gains, the credit-rating and stock-research firm decided companies would have no such gains this year, with the S&P 500 having lost 23 percent year-to-date.
`Leap of Faith'
Companies such as General Motors Corp. and Boeing Co. have cut their earnings forecasts because they may have to add to pension funds to make up for poor investment performance.
``We're making a leap of faith and saying that companies didn't have a gain this year,'' Silverblatt said. That assumption is ``pretty safe'' in a year when the S&P 500 has fallen.
If the market has double-digit gains over the next 12 months, the $4.50 charge against core earnings would disappear.
Gallagher said he agrees that pension investment gains should not be used to boost earnings, and he makes that adjustment to his own profit forecasts.
The problem with this approach, according to Gallagher, is that it will make core earnings rise and fall with the stock market. Core earnings could be $4.50 higher a year from now simply because the stock market is higher, independent of any improvement in the outlook for corporate earnings.
``I think they blew the opportunity,'' Gallagher said.
This article was first posted on Les's excellent thread.
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