Hi Pat,..Re:.Income/eps based comparisons
More boring stuff from what we were discussing yesterday about using earnings rather than revenues.<g> From the article below, the writer discusses some of the pitfalls in using operating income in making performance comparisons. But he doesn't go into cash flow evaluations enough.
Use it for your sleeping pill later on! <g>
Cheers,
Lee
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Message 13506853
Dow Jones Newswires
POINT OF VIEW: What's Operating Income, Doc?
By SEAN DAVIS
NEW YORK -- Some words and phrases mean whatever the utterer wants them to mean. Take "interesting," for example. Said in one tone of voice, it means alluring or intriguing. Said in another, it means peculiar or flat-out wrong, as when a politician says to a rival, "I find your views rather interesting."
Wall Street has such a phrase. It's called operating income, and increasingly, it means whatever a company wants it to mean. Unfortunately for the investor trying to figure out how a company performed in a given quarter, this chameleonlike quality renders the phrase practically meaningless.
Traditionally, operating income meant income from the company's ongoing businesses. A big charge for restructuring, or a big gain from the sale of a business, would be excluded from operating income because these were one-time phenomena. Including them would yield an unreliable stock valuation, which as everyone knows is based on a multiple of net income.
But somewhere along the way, companies began excluding from operating income gains and expenses that occur just about every quarter.
Right now, the question roiling Wall Street is what to do with investment gains? These stock-market profits increasingly are adding to the bottom lines of companies outside the financial-services sector. Take Compaq Computer Corp. (CPQ), for example: stock market gains contributed 3 cents of its 19 cents-a-share profit in the first quarter.
The majority of analysts following Compaq excluded investment gains from their published estimates, but that was news to First Call/Thomson Financial, which keeps track of Wall Street research, because in the fourth quarter, analysts included investment gains in their published estimates. First Call, which typically reports operating income, had to go back and change the numbers on its machines after learning of this change in tack by the Compaq analyst community, according to Charles Hill, First Call's director of research.
There are two ways to look at investment gains and losses. A company like Compaq isn't in the business of buying and selling stocks. Any investment gains it realizes are, in theory, side effects of its investment activity, which is designed to forge stronger alliances with business partners, not to generate investment profit. By this reasoning, investment gains don't belong in operating income. On the other hand, most companies have investment activity every quarter, so why should investment gains and losses be treated as one-time phenomena?
Another topic of controversy is goodwill amortization. This is a regular, predictable expense at most companies. When a company pays more than the book value for another company it acquires, and it uses purchase accounting, it must write off the difference over a fixed period. Even though these write-offs occur strictly on paper, with no effect to cash flow, they are the cost of doing business, as far as accounting rules go, and therefore belong in the expense part of the profit statement.
But many technology companies that have grown through acquisitions don't like showing investors losses quarter after quarter as a result of these write-offs. So in their press releases, where they have a bit more wriggle room than in their filings with the Securities and Exchange Commission, they highlight such measures as "adjusted net income" or "pro forma income," leaving out these recurring write-offs to show a profit instead of a loss.
To be sure, cash flow, which is what these other measurements amount to, is an important measure of financial performance. If a company wants investors to know how much money is flowing into the enterprise, that's fine. Just don't call cash flow "adjusted net income" or some other misleading term that conveys the impression it is the equivalent of net income, which it isn't.
Another regular expense that some companies have taken to excluding from operating income is the amortization of stock-based compensation. Issuing stock as if it were Monopoly money may be painless way to retain key talent. But investors should ask these companies and the analysts who follow them: Isn't paying employees one of the costs of doing business? If so, doesn't it belong in the calculation of operating income?
As with the English language, usage will dictate in the end what is right and what is wrong. First Call's Hill says when a majority of analysts exclude an item from operating income, that's what First Call does. Right now, analysts aren't in unanimity. For instance, Intel's analysts include investment gains in their published estimates; Dell's analysts don't.
For investors, this means a bit of guesswork is required. Does an analyst's price target for a stock include or exclude investment gains? What about goodwill amortization? Until Wall Street arrives at a new consensus on the measure of a company's performance, this guesswork will continue, making it harder for investors to allocate capital as efficiently as possible, which is the point of the stock market to begin with.
-Sean Davis, Dow Jones Newswires; 201-938-5294; sean.davis@dowjones.com
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