Accurate Earnings Measurements During Times of Uncertain Earnings

Journal Issue

Nov 2002

Column Name

Journal HTML Content

It is no secret that investors are increasingly being required to take a more critical
look at corporate financial statements. As stories of corporate fraud proliferate,
casual and professional investors alike have begun to take new precautions in educating
themselves about the validity of publicly released data. Getting up the curve has been
costly, however, as many are only now beginning to conduct the fundamental
investigation that has for a long time been taken for granted.

A recently published Merrill Lynch report on earnings quality entitled Towards a 360°
View of Reality addresses the investor's perception of a widening gap between corporate
financial reporting and "reality." The report cites a study by the ML Global
Strategy Group in which a group of fund managers was surveyed regarding their opinions
on the quality of earnings present in the financial statements of U.S. companies
versus those of their peers in other global markets. In March 2002, 43 percent
of managers believed U.S. equities were the most reliable, while only 9 percent
thought that U.S. equities were the worst. In July 2002, the same survey among
the same group revealed a monumental shift in opinion, with a mere 19 percent
retaining their confidence in U.S. numbers. The percentage feeling U.S. companies
had the worst quality of earnings skyrocketed to 34 percent.

In the current environment, investors, lenders and others who rely on reported
financial information are showing a new skepticism about the quality of earnings on many
levels. Stories about major U.S. corporations manipulating earnings have been in the
headlines for much of the past year. In this article, we do not attempt to delve
into the multitude of issues behind this phenomenon, but rather we focus on the
subject of different earnings metrics and how each can present a different level of
"quality of earnings." We address Earnings Per Share (EPS) under generally accepted
accounting principles (GAAP) as well as two common alternative measures of
performance, pro-forma EPS and cash EPS, and discuss the evolving roles of these
metrics in today's reporting environment.

GAAP EPS is considered by many to be the most meaningful data point among the
various earnings statistics, as it is the byproduct of many years of accounting study
and rulemaking by bodies of independent standards boards. EPS figures are intended
by design to provide an accurate proxy for measuring an enterprise's results and
progress over multiple reporting periods, providing a standardized, highly documented and
widely known basis for comparison.

In short, GAAP EPS captures the net per share economic production of a
company's operations over a fixed period of time after all costs arising from the
operation of the business have been deducted from the revenue it has produced. The
actual calculation of EPS is fairly straightforward from a macro perspective, typically
beginning with revenue, then subtracting cost of goods, operating expenses,
depreciation, amortization, interest and taxes to come up with net income
(numerator). Net income is then divided by the total shares outstanding (denominator)
to determine the EPS figure.

Total shares outstanding is normally reported for both primary and diluted shares.
Primary shares represent those shares that are currently issued and outstanding. The
diluted shares amount represents a more conservative position, as it encompasses all
"common stock equivalents," including warrants, convertible debt, in-the-money options
and other instruments that would dilute primary ownership in a liquidation scenario.
More often than not, investors focus on the diluted number, as the existence of
common stock equivalents will have a real impact on per-share values.

The extent to which EPS is relied upon to determine a company's relative performance
is no more evident than in the emphasis placed on those numbers by corporations at
the end of each reporting period. Additionally, the direct and immediate reaction of
the financial markets to EPS announcements highlights the underlying assumption of
integrity placed in such figures by the investing public.

The strength of EPS methodology lies in its ability to produce a "general purpose"
set of financial data. However, while EPS does effectively standardize, it does
nothing to normalize, which some would argue is the very reason its "quality of
earnings" value is lower. This perceived weakness has given rise to myriad alternative
reporting methods, all of which intend to communicate a company's relative status more
meaningfully.

Perhaps the most common alternative reporting metric, pro-forma EPS typically begins
with GAAP EPS and adds back the net effects of M&A fees, restructuring charges,
asset impairments or other expenses considered atypical or non-recurring. Other common
pro-forma addbacks include in-process R&D expenditures, goodwill amortization charges,
stock compensation expenses and costs associated with the capitalization of intangible
assets. The term "pro-forma" indicates that assumptions or hypothetical conditions have
been built into a certain data set when calculating EPS. The methodology essentially
attempts to isolate a company's results in a "normal" operating environment.

A pro-forma number could be valuable to an investor in a case where a company
took a one-time charge relating to a specific, definable event. The case could be
made that the pro-forma evaluation in this situation more accurately reflects the
company's long-term prospects relative to GAAP-based analysis. This conclusion would
obviously depend on the likelihood that an event of similar magnitude would not happen
on a regular basis. Many companies, particularly those in financial distress, have
made a habit of identifying "one-time charges" quarter after quarter, clearly signaling
that continued adjustments for such items may not be appropriate.

The obvious concern about any pro-forma methodology is that it could potentially
hide, obscure or inflate a GAAP EPS number given that it is not bound by any
specific accounting standards. Indeed, reporting entities have substantial leeway in the
presentation of pro-forma results. They do, however, face scrutiny and potential
enforcement actions by the SEC, stock exchanges or others if releasing misleading
press or financial statements, or failing to adhere to guidelines requiring full and
fair disclosure.

This is somewhat encouraging for investors in search of "quality earnings," but due
to the subjectivity of pro-forma figures, this metric requires more scrutiny than
GAAP-based results.

In The FASB Report dated Feb. 28, 2002, the author notes that "the
widening gap between pro-forma and U.S. GAAP EPS relates to a dramatic increase
in the magnitude and frequency of expenses that are being excluded from pro-forma
earnings." Increased use of non-recurring classifications through pro-forma evaluation
seems to have desensitized many investors, who have adopted somewhat of an
"out-of-sight, out-of-mind" mentality as it relates to the real effects of unusual
items. While perhaps "one-time" or unusual in nature, many of such items have a true
economic cost to the business enterprise, and such cost cannot be overlooked in
assessing the value of a business or its stock.

A recent study by University of Michigan researchers concluded that there is a
strong degree of correlation between the level of companies' excluded expenses in their
pro-forma presentations and their actual cash flows during future periods. Additionally,
the study found a significant difference between the stock returns of firms with high
vs. low amounts of excluded expenses, with stock returns up to 45 percent lower
for firms with relatively large exclusions, compared with those firms with small
exclusions. The primary implication of this research is that the nature of excluded
expenses is such that they truly impact on cash flows and value. One might also infer
that companies that underperform in the market are more likely to attribute negative
aspects of performance to "one-time charges" and other excluded expenses.

With all of the concern about pro-forma presentations, should they simply be
ignored? We believe the answer is no, but that they should not be used as the
primary measuring stick of performance. Any analysis of pro-forma operating results
should be accompanied by other analyses, and it is critical to understand the true
nature of the pro-forma adjustments when making the evaluation.

A second alternative metric, cash EPS, is typically calculated as some form of
operating cash flow on a per-share basis, and attempts to provide a per-share
operating proxy that most accurately reflects the true net amount of cash flowing into
a company during a reporting period.

One of the most common iterations of the metric begins with GAAP EPS and adds
back the tax-effected impact of non-cash goodwill and intangible amortization costs.
Other versions add back tax-effected, non-recurring charges as well.

Widespread use of cash EPS began in the mid to late 1990s as companies
increasingly sought to grow by acquisition and to enhance their global presence, driving
M&A activity to all-time highs. The huge amounts of goodwill associated with the
acquisitions resulted in a substantial hit to earnings for many companies, especially
the fabled "new economy" darlings that had acquired competitors operating from very
limited asset bases.

Cash EPS helped to alleviate some of the pain that came as a result of using
purchase accounting and was thought by some to provide a more relevant basis for
evaluation. Proponents of cash EPS supported their position by arguing that the
recording of intangible assets did not affect the amount of cash flowing into and
out of a company, and the subsequent deduction of amortization unnecessarily increased
discrepancies between operating cash flow and GAAP net income.

However, with the final implementation of FAS 141 and 142 in 2001,
cash EPS became substantially less of a long-term issue as the periodic amortization
of acquisition goodwill and pooling accounting were both eliminated. Cash EPS figures
are still seen in financial reports today, but are typically applied on a pro-forma
basis to pre-FASB 141/142 figures when presented against current results.

Should cash EPS be considered an appropriate measure of a company's performance?
Again, like pro-forma EPS, we believe that it is one measure that should be
considered, but not in a vacuum. Investors are interested in a company's net income,
but an analysis that does not look at cash flow and other measures would be
incomplete.

In the search for quality earnings, one thing that is encouraging to the
investing community is the sheer quantity of information that is available for
evaluation. The high level of disclosure required in the United States is exactly
what enables us to take our own, customized measurements of corporate success. While
the challenge may seem daunting to some, not having any information at all would no
doubt be much worse.

Given the recent problems with financial reporting, it is now more important than
ever for the investor to fully appreciate the differences between results reported under
different methodologies. When non-GAAP information is provided, the motivation of
management should be considered, and alternative measures should be evaluated. Metrics
such as EPS, pro-forma EPS and cash EPS should be assessed, and reliance shouldn't
be placed on a single measure, as each has its own strengths and weaknesses. A much
more inclusive evaluation of quantitative and qualitative metrics alike will provide the
best interpretation of value and help in the evaluation of quality of earnings.

Journal Authors

Alan D. Holtz

Journal Date

Friday, November 1, 2002 - 12:00

Bankruptcy Rule

2002