Core earnings useful gauge of long-term performance

PERSONAL FINANCE

August 18, 2002|By EILEEN AMBROSE

Core earnings useful gauge of long-term performance EVEN before the accounting scandals, the financial analytical firm Standard & Poor's figured something had to be done about the reporting of corporate earnings.

Growing pressure to live up to Wall Street's expectations prompted companies in the past decade to devise new earnings measures that put their results in the most favorable light, according to S&P.

"It was beginning to get ridiculous," said David Wyss, S&P's chief economist in New York. "We found one [company] that we counted seven different definitions of earnings."

One of the measures most frequently complained about is pro forma, in which companies report what their earnings would be "as if" some event hadn't occurred. When applied liberally, pro forma has been jokingly dubbed EBBS, or Earnings Before the Bad Stuff.

"There has been such a wide range of numbers that investors have been led to believe that are useful measure of performance, and most of them are not," said John Hussman, portfolio manager of Hussman Strategic Growth Fund in Ellicott City.

Last summer, S&P set about developing a new measure. The result is core earnings, a measure of the after-tax earnings of a company's primary business.

Investors are likely to be hearing a lot more about core earnings. Next month, S&P expects to complete its work on the core earnings for last year and the first half of this year for the companies that make up its S&P 500 index. Core earnings will appear on S&P's Web site and in some research reports.

Some academics, accounting specialists and money managers say they hope that core earnings, or something like them, becomes the standard.

Core earnings aren't the only numbers investors should look at, but some experts say the measure is a useful one. Net income remains the important number for the financial results of the entire company, but core earnings seek to gauge the direction of the company's main line of business over the long term.

"We think this is the best measure of the actual return to the shareholder," Wyss said. "This is what you got in return for that share of stock you bought."

Investors will notice that core earnings will be less than net income, said David Blitzer, managing director of S&P's index committee. Blitzer said he doesn't have firm figures on how much lower.

For example, though, Cisco Systems' loss last year jumps from 14 cents a share to 35 cents under core earnings, and General Electric's profit falls from $1.41 a share to $1.11.

That's because of additions and subtractions under core earnings, including:

Employee stock options. Most companies, including Cisco, don't count options as an expense on their income statement.

Options are part of core earnings. "Options are a cost of doing business; they are a real cost to the shareholder," Wyss said.

When exercised, options increase the number of outstanding shares and dilute the ownership of existing shareholders. And if a company tries to counteract that dilution by buying back stock, it's spending money that could have been plowed back into the business.

Pension gains. Sometimes, particularly during the last bull market, the investment returns in traditional pension plans brought in more income than needed to cover future liabilities. Accounting rules allow excess profits to be counted as income. Many companies with overfunded pensions, including General Electric, saw their bottom lines pumped up by this.

But core earnings ignore pension gains. The profits have nothing to do with the main business and, unless the plan is terminated, the money can't be tapped by the corporation, Wyss said.

Restructuring charges. The cost of employee layoffs, terminating leases early or other one-time expenses related to restructuring continuing operations are included in core earnings. But one-time charges not related to the principal business, say, the sale of property or a lawsuit settlement, won't be.

Core earnings aren't a cure-all for what ails corporate accounting. "It wouldn't have uncovered Enron before they crashed," Blitzer said.

Jeremy Siegel, a finance professor at the University of Pennsylvania's Wharton School, is among those hoping that core earnings become a standard measure of profitability. "It won't be a slam dunk, there is a lot of resistance," Siegel said.

Dean Krogman, a vice president with Financial Executives International, a trade association for treasurers and chief financial officers, said he favors any changes in the reporting of earnings to come from the Financial Accounting Standards Board, the private organization that sets accounting rules. If S&P and other groups create their own measures, he said, it might add to investor confusion.

Whether or not core earnings become the standard, money managers say, people must look at more than just one figure before investing.

"They should look at this as a reminder to be skeptical" and "a reminder that investing requires careful research," Hussman said.

"I'm constantly amazed that people will spend a week analyzing Consumer Reports before buying a refrigerator or a television set, but invest their life savings based on a company having an attractive p/e ratio when the earnings the p/e ratio is based on may be completely misleading," he said.

To suggest a column idea, contact Eileen Ambrose at 410-332-6984 or by e-mail at eileen.ambrose@baltsun.com.

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