EARNINGS EXPLAINED -- Don't Get Burned
You can't trust companies. Can't trust auditors. Can't trust analysts. So getting the truth about earnings is up to you. FORTUNE explains how to play Columbo.
FORTUNE -- Monday, February 18, 2002
By Shawn Tully
As investigators untangle the complicated accounting at Enron, your own financial health depends on asking a simple question: What are earnings? Ignore the accountants, the analysts, and the brokers who snigger at your stupidity. You're being dumb like Lieutenant Columbo.
They're smooth-talking villains who have a vested interest in confusing you. The Enron collapse, the nagging questions about Tyco's accounting, the suspicion that many of America's most celebrated companies aren't nearly as profitable as they claim to be, make it imperative that you, the investor, get to the truth on earnings. When figures confound and experts confuse, you need to take a deep breath and do the math yourself. Can you? Sure. Think of what follows as Accounting for Dummies.
Companies--and Wall Street--want you to accept an inflated version of earnings, because strong earnings make stock prices soar. "Many Wall Street analysts set up meaningless targets that companies can meet or beat, which tends to drive up stock prices," says Marty Whitman, a value investor who runs the Third Avenue Funds. Legally most companies are doing nothing wrong. They use perfectly acceptable tactics to manipulate the official numbers the SEC requires--called GAAP earnings (for Generally Accepted Accounting Principles). But by exploiting GAAP's flexible rules, the companies violate its spirit. And their earnings are not what they seem.
It's easier than you think to penetrate the smoke screen. FORTUNE will help by giving you four warning signs that indicate a company might be inflating its earnings. After you've looked for red flags, you should adjust the GAAP figures for a large expense that almost no company includes, because GAAP does not require it: the cost of stock options. Now you're near the true bottom line.
But we're ahead of ourselves. Before we crunch numbers, let's define earnings. They are the wealth a company creates for its owners by selling its products or services. Accountants measure earnings by subtracting costs from revenues. What's left is profit. The best measure of profit is "net income," as defined by GAAP. Under SEC regulations, all publicly traded corporations must report GAAP profits--even though many of them bury these precious figures at the bottom of their press releases.
When companies don't game the numbers, GAAP figures are the gold standard. They include all the costs and all the revenues incurred in the year or quarter. "GAAP earnings are like a newspaper," says Jack Ciesielski, author of the influential newsletter The Analyst's Accounting Observer. "They include all the news--everything that happened during that period." The trouble is that companies, cheered on by Wall Street, try to censor the news. In their press releases they emphasize not GAAP earnings but "pro forma" profits or Ebitda (earnings before interest, taxes, depreciation, and amortization).
Pro forma earnings typically exclude write-downs and restructuring charges as "nonrecurring." But closing plants and changing products are ongoing parts of doing business, not nonrecurring aberrations. And they cost shareholders real money. Companies that use Ebitda, which include cable giants AT&T, Viacom, and AOL Time Warner (parent of FORTUNE's publisher), not only leave out expenses like taxes and interest but also exclude depreciation, thus hiding the large cash investments needed to keep their cable systems competitive.
Because companies can manipulate GAAP numbers quite legally, FORTUNE--guided by Baruch Lev, a professor of accounting and finance at New York University--came up with these warning signs that earnings have been gussied up.
Frequent Restructuring Charges and Write-Downs
Companies constantly exit markets, change product mixes, and close plants. Be on the lookout for those that turn such routine activities into one-time charges. When a company takes a restructuring charge, it estimates the cost, say, of closing a sales office, including everything from severance to absorbing lease expenses. It takes the entire charge right now, even though it may not close the office until next year and may keep paying people even longer. By concentrating the costs in a single reporting period, the company makes future earnings appear higher than they are. Not all companies do this. Despite the cyclical nature of the oil business, Exxon Mobil has a policy of counting the expense of closing plants and shedding products as normal operating costs.
Companies generally establish reserves to cover the costs of restructuring; those reserves invite abuse. Frequently management can't resist setting up a larger reserve than necessary, thus enabling it to pump what it doesn't pay out in severance and other costs back into earnings the next year. Voila! Earnings get a phony fix. Sunbeam, Cendant, and Waste Management all camouflaged immense problems by reversing reserves. In 1997, as Sunbeam's business was collapsing, Al Dunlap used reserve reversals to report an enormous increase in earnings.
Write-downs are another sign of trouble; in effect, they tell you a company has made a mistake. Last April, Cisco wrote off $2.5 billion in inventory. The company said that because demand for its routers and switches had declined, their value had too. But why? "They don't take a special profit when the value of their inventory goes up in a good market," says Howard Schilit, president of CFRA, a firm that analyzes financial statements for institutional investors. Adds Lev: "With Cisco's highly touted control system, how could it get stuck with $2.5 billion in surplus inventory?" If Cisco hadn't taken the charge, it would have sold the routers at a loss or thrown them out over the next few quarters. That would have depressed profits. By taking an immediate write-down, Cisco produced cosmetically enhanced earnings for the next few quarters.
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