What do big companies really earn? Between the bear market and prosecutions of CEOs for accounting fraud, investors badly want to know. But they might not like one of the latest answers: less than half what Wall Street says and about a third less than companies themselves report under generally accepted accounting principles (GAAP).
That's the outcome of a yearlong search to identify "core earnings" by Standard & Poor's, like BusinessWeek a unit of The McGraw-Hill Companies. The main reasons for the huge differences? Rigorous accounting for stock options and pensions. Those two factors weigh heavily enough in the core earnings calculations to slice more than $5 and $6, respectively, off the roughly $27 per share that companies in the Standard & Poor's 500-stock index reported as net earnings for the 12 months that ended in June. Wall Street's rose-colored numbers, collated by Thomson First Call, put average earnings per share at around $45.
Naturally, not everyone is happy with S&P's downbeat numbers or the way that they're calculated. Even before S&P published its findings on Oct. 24, some accounting experts said its methods were inconsistent. All the same, the numbers give investors a first glimpse of what truly clean accounting might look like.
For starters, the current valuations of stocks look awful. Shrinking the earnings companies report under GAAP by 31%, as S&P's core numbers do, catapults the average price-earnings multiple for the S&P 500 from a recent 33 to 48, a level likely to make stocks unattractive to many. Plus, the earnings yield on stocks falls to just 2%, or about half the yield of 10-year Treasuries.
S&P's conclusions foreshadow the possible results of an accounting overhaul. More than 110 companies have announced since May that they will begin expensing stock options. Already, the Financial Accounting Standards Board, keeper of GAAP, is mulling whether to make companies estimate options costs quarterly. Interest is also gathering for overhauling accounting for pensions. On Oct. 21, FASB said it is looking to refashion its code so that companies won't be able to find as many loopholes as they do now.
But FASB's overhaul may take years. In the meantime, Wall Street investment houses and research companies like S&P aren't waiting. David M. Blitzer, an S&P managing director, says GAAP hides from investors the true risk and cost to companies of their pension plans. That's becoming crystal clear as more companies 'fess up that they need to pump cash into the plans to make up for stock market losses.
Even if core earnings do not become a standard, Standard & Poor's results may add fuel to the drive for accounting reform. The new numbers underscore just how important it has become for regulators to hurry up and set the books straight.
Two .pdf files (which require Adobe's Acrobat Reader) are available from Standard & Poor's: A Technical Bulletin that explains how S&P arrives at its core earnings number and how the current definition has been revised from the original issued in May, 2002; and a Market Review that explains in detail the results of the latest core-earnings study.
Also, BusinessWeek Online has prepared an Interactive Scoreboard showing 12-month trailing earnings as of June, 2002, for all the companies in the S&P 500. It shows both reporterd earnings and the S&P core earnings for each of the S&P 500. By David Henry in New York