Will the real earnings decline please stand up?
In a sign of how confusing earnings calculations have become, two well-known financial-services companies are reporting widely different second-quarter corporate-profit declines for the Standard & Poor's 500-stock index of large companies.
S&P, the unit of McGraw-Hill Cos. that compiles the index, says that so-called operating earnings have fallen 32.9%, to $9.99 a share, compared with one year ago. But Thomson Financial/First Call puts the decline at just 17%, to $11.81 share. Both figures are preliminary as both First Call and S&P continue to adjust them throughout this quarter.
Companies Pollute Earnings Reports, Leaving P/E Ratios Hard to Calculate (Aug. 21)
The gap is the widest it has been in at least the past 10 years. A small part of the disparity results from the use by each service of a slightly different set of companies in the second quarter this year and last, which, among other things, resulted in differing baseline numbers. But the biggest part of the gap reflects a growing disagreement between First Call and S&P over the expenses companies should be allowed to exclude and have treated as "special items" in their so-called operating-earnings figure.
Over the past several quarters, S&P has taken a tougher line than First Call, refusing to exclude expenses that it considers part of normal operations. But First Call says it follows the lead of Wall Street analysts, backing out the same expenses they do.
For example, First Call puts the earnings for Loews Corp. at $1.14 a share, excluding most of the losses that the company and analysts treated as "one time." S&P treated those expenses as ordinary costs of business and recorded a loss for Loews in the second quarter of $7.18 a share.
For investors, the disparity adds to the growing problems of how to gauge the market's value at a time when more and more companies are presenting glossy earnings that exclude expenses that they call special, unusual or one-time. These include charges for restructuring and layoffs, and write-downs in asset values.
The gap is significant because "investors need to assess what they are benchmarking against and need to gauge how their portfolio is performing," said Karina Mayer, managing director at International Strategy & Investment Group Inc., a New York economic-research firm.
Operating earnings differ from operating income and net income, which have strict definitions under generally accepted accounting principles. Virtually all of the expenses that companies call "special" are treated as regular charges under GAAP and can't be excluded. Despite its fuzziness, operating earnings is the profitability figure most widely watched by Wall Street analysts and many investors. When a company announces earnings that meet or beat "the Street" -- a significant factor that often moves a stock -- it does so based on the difference between estimated and reported operating earnings.
But the gap between operating earnings and earnings calculated according to GAAP standards has widened in the past several years as companies have taken to excluding a broad array of ordinary expenses in their earnings releases in an apparent attempt to meet Wall Street expectations.
And now, the gap between the two different operating-earnings figures is growing as well, creating confusion over the market's value. Based on the previous four quarters' operating-earnings estimates, S&P figures yield a price-to-earnings ratio of 24.2 for the S&P 500. The First Call numbers yield a P/E of 22.2. Based on earnings as reported under GAAP, excluding a very limited range of expenses known as "extraordinary items," the S&P 500 finished Wednesday with a P/E ratio of 36.8, the highest ever recorded for the index, according to a Wall Street Journal analysis.
In the staid world of data gathering, the gap has led to some strong words from both sides over how they calculate their figures. In an interview, Chuck Hill, director of research at First Call, accused S&P of acting like a self-appointed "earnings pope," including expenses in its operating earnings that most analysts believe should be excluded.
Howard Silverblatt, editor of quantitative services at S&P, responded: "We have no problem with being the pope. It is our index, and it is our name that we are dealing with." He said the company was actually reviewing its standards and would likely grow more conservative in choosing to accept "special items."
New York investment banker Gary Lutin said the gap shows the dangers of using operating figures in any situation, because there is no standard.
"It could just be a question of what color fairy dust you prefer," he said. "The issue is really whether you should do anything that strays away from reality-based numbers."