Berney: The difference comes from the distinction between "operating
earnings" and "net profit".
For example, assume that in 1997 the fictional XYZ Corp. earned
$100mil in its ongoing business activities. Its operating earnings,
then, would be $100mil.
But, further assume that in 1997 one of XYZ's factories, being
carried on the books at a value of $100mil, is destroyed by a flood
-- and that floods are not covered by XYZ's insurance. Under these
circumstances, XYZ has suffered a (hopefully) "nonrecurring" or
"extraordinary" loss of $100mil. By this reckoning, "net profit" is
zero, and XYZ's p/e is "NM" (not meaningful).
The news services that feed financial info to newspapers generally
use these net profit figures in computing p/e. However, Value Line,
because it is interested in projecting future earnings power (and so
assumes that floods, etc., will not keep recurring), uses operating
earnings in calculating its ratios, and would therefore use the
$100mil operating earnings figure in computing XYZ's p/e.
Boeing merged with McDonnell Douglas, and Int'l Paper and Kodak did
a lot of shutting down of excess capacity, in 1997. Therefore, they
show large "extraordinary" expenses in connection with these
activities. Using the Value Line data for these companies (which
contains only estimates for 4Q 1997), and closing prices for Friday
2/27/98, the operating p/e's on these 3 companies are:
Boeing 83.4
Kodak 19.0
Int'l Paper 46.6
Note: The example given of XYZ Corp. is highly simplified. But
suppose, for example, that XYZ is in a flood zone (and therefore
can't get affordable flood insurance). If so, was the loss of the
factory really "nonrecurring"? Shouldn't flood risk be deducted from
estimates of future earnings power?
Some of these issues are further amplified in the real-life
comparison of WorldCom and AT&T ("Determining the Indeterminate") at:
web.idirect.com Public List
As the subtitle indicates, this subject has no simple resolution.
Part of the problem is that the very nature of the "extraordinary"
or "nonrecurring" is that it evades easy generalization.
Using cash earnings (operating cash flow minus capital spending)
addresses a part, but not all, of this problem. In the XYZ
example, the future expense of replacing the lost factory would show
up as "capital spending" (and therefore be deducted from cash
earnings) in the periods in which the money is actually spent --
rather than being "disappeared" from future net profit figures in a
single fiscal quarter's "nonrecurring" expenses.
Reynolds Russell web.idirect.com
"There are no sure and easy paths to riches in Wall Street or anywhere
else." (Benjamin Graham) |
