The confusion over corporate earnings

Posted: Jun 06, 2002 12:00 AM
One of the more puzzling aspects of the economy today is the lackluster performance of the stock market. Historically, it has been a leading indicator of the economy, if not necessarily an infallible one. Hence, a lagging stock market may indicate that future economic growth prospects are not as rosy as economists have thought. Alternatively, the Enron-induced cleanup of corporate accounting may be confusing investors about the true state of corporate profitability. Although most economists have been fairly bullish on the economy since the first of the year, there have always been a few naysayers warning of a so-called double-dip recession. They say that recent positive growth numbers, such as the 5.6 percent increase in real gross domestic product in the first quarter, are the result of temporary factors, such as the restocking of inventories, and do not guarantee that the economy is now on a firm upward trend. Another group of economists were previously bullish, but have turned somewhat more pessimistic lately as the result of actions taken by Congress and the Bush administration. They point to the imposition of steel tariffs, which increase the cost of business for many companies; the farm bill, which has all but killed the chances of a meaningful new trade agreement even if the president gets "fast track" trade authority; and an apparent backtrack by the administration on global warming, which could lead to the imposition of massive new regulations on virtually all American businesses. Hovering over these concerns are continuing uncertainties about war and terrorism; future Federal Reserve policy, with some economists already urging it to raise interest rates; and the outcome of midterm elections in November. Many of the administration's most criticized actions have been taken, perhaps against President Bush's better judgment, in part to improve Republican chances of keeping the House and retaking the Senate. However, they do not appear to be having that effect. At present, experts say the most likely electoral outcome is maintenance of the status quo. These points are well taken and no doubt are casting a pall over the stock market. However, I believe that the most important factor holding back stocks is the enormous confusion about corporate earnings. Investors are disgusted by fraudulent profit figures put out by companies such as Enron, Tyco, Global Crossing and Adelphia Communications. And they are deeply skeptical of those put out even by "blue chip" companies such as General Electric. Investors have good reason to be skeptical. One of the factors that fueled the dot-com bubble was the pervasive use of a non-standard method of calculating profits called "pro forma earnings." This term was originally intended to provide guidance for investors when a company underwent a major change, such as a merger, which made comparisons with previous earnings difficult. However, the reporting of pro forma profits was badly abused by many now-bankrupt dot-coms, which used it as a way of hiding factors that negatively affected earnings. Another important area of confusion is stock options, now used by almost all big corporations to compensate their employees. In effect, stock options dilute earnings, but their impact has not been apparent to investors. The data are often buried in footnotes in annual reports and reported in ways that are difficult even for accountants to interpret. But their impact is huge -- reducing reported profits by roughly $5 per share for all companies in the Standard and Poor's 500 index. Many in Congress are calling for accounting changes, such as requiring companies to deduct stock options from reported earnings. However, new legislation is totally unnecessary because investors are already demanding such information. On May 14, Standard and Poor's announced that it would soon begin calculating its widely used company earnings figures to include the value of stock options as well as other items, such as gains on company pension plans, that have often been used to artificially inflate earnings. The new measure of profits is called "core earnings," and it attempts to gauge how companies are really doing in their primary business operations. In the case of General Electric, the calculation of core earnings shaved close to $1 billion off its reported profits in both 2000 and 2001, according to Standard and Poor's. Almost daily, there are fresh reports of large profit write-downs at major corporations, despite an improving economy, as companies clean up their books and try to produce earnings data markets will trust. In the meantime, investors must also labor to interpret them and calculate appropriate values for stocks based upon them. Until this process, which could go on for months, is completed, the stock market will probably struggle to rise much above current levels.