Finding Stocks’ True Value

Everybody now wants corporate accounting to be clean and accurate.

But greater honesty in accounting has implications for the stock market that may leave some investors pining for the good-bad old days of financial obfuscation.

If earnings have been overstated by accounting gimmickry, then the high prices paid for stocks in the boom years of the late 1990s were even higher than they seemed.

Likewise, if reported earnings grow more slowly in the next few years because accounting is more honest, then current stock valuations--which are down from their bull-market peaks, but are hardly cheap, historically--also may be higher than they appear.

How much these issues are contributing to the stock market’s woes this year is impossible to measure. They are major topics of discussion among Wall Street economists and market strategists. But this kind of stuff can take a long time to sink into investors’ psyches.

It should sink in, however, because measuring the prices of shares relative to underlying earnings isn’t supposed to be some mere academic exercise. Investors are supposed to be interested in a given stock because they’re interested in owning a piece of the company’s current and future earnings power.

Long, long ago, investors received their piece of corporate earnings directly, in the form of cash dividends paid by companies. But as dividends fell out of favor in the late 1990s--in part because many companies correctly determined that investors didn’t want bigger dividends because of the tax bite--the long-term earnings payback to shareholders became almost exclusively a function of share-price appreciation.

That was fine when share prices were appreciating. But the last two years have mostly been about depreciation. If you want to believe the worst is over, then many of the stocks with the best appreciation potential from this point ought to belong to companies whose earnings growth will be strongest in the next few years.

Which brings us back to the question of what constitutes genuine earnings.

With the sudden passion to discover what was real and what was fake about corporate earnings in recent years, some economists are comparing two broad measures of results: the “operating” earnings figure for the blue-chip Standard & Poor’s 500 index, and total U.S. after-tax corporate profit as reported in the government’s “national income and product account” report, or NIPA.

The S&P; 500 figure, measuring results of the largest publicly traded U.S. companies, is the gauge most often quoted in the media. Operating earnings are supposed to tell investors what a company earned from its basic business in a particular period, excluding so-called one-time gains or losses, such as from the sale of a piece of the firm.

As investors now know all too well, operating earnings data have been manipulated in recent years to the point where no one is exactly sure what they mean, other than that they measure profit excluding often unpleasant, albeit important, things a company would like investors and analysts to ignore.

The NIPA results, by contrast, are based on information reported to the Internal Revenue Service by all incorporated businesses, public and private.

Scott Grannis, economist at Western Asset Management in Pasadena, calls NIPA earnings “the best measure of true [corporate] profit” because they are based on after-tax numbers.

Economist Edward Yardeni, the newly named chief investment strategist for Prudential Securities in New York, also points out that NIPA earnings are reduced by the cost of stock options companies granted to workers. The accounting for such option costs has become a hot button in the post-Enron era: Many companies claim a tax deduction for option costs without officially charging the costs against earnings.

Some in Congress now want to force companies to book their options expenses so shareholders can plainly see them. Investor Warren Buffett has long pressed for that. As he wrote in his Berkshire Hathaway Co. annual report a few years ago: “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”

The effect on companies’ bottom lines if they’re forced to include options as an expense would vary, but it could hit some technology and telecom companies’ particularly hard--just as those firms are trying to rebound from the capital spending plunge of the last two years.

Back to NIPA earnings versus S&P; 500 operating earnings: Yardeni notes that both NIPA earnings and S&P; earnings surged between 1992 and 1997. But then the NIPA results stalled out, while the S&P; results continued to rocket from 1998 through mid-2000.

Since mid-2000, both measures have been plummeting. But why should the S&P; companies have had dramatic profit growth from 1998 to 2000 while total U.S. corporate profits had stalled?

It may have been that the biggest companies simply did a far better job of running their businesses in that period, compared with most other public and private companies. Post-Enron, though, many analysts believe that strong S&P; operating profits were at least somewhat illusory, thanks to many perfectly legal accounting tricks and some that were either illegal or borderline.

With the recession, the discrepancy between S&P; operating earnings and the bottom line for those companies after including all “special” write-offs and charges widened dramatically last year. In the third quarter, S&P; operating earnings were down 14.5% from a year earlier, Yardeni said. But S&P; results including all special items plummeted 47% from a year earlier.

No wonder companies want investors to focus on operating results when valuing shares.

Yet some analysts argue that it would be absurd to value stocks purely on earnings according to generally accepted accounting principles, especially in an economic downturn.

Steven Wieting, economist at Salomon Smith Barney in New York, notes that while total write-offs recorded by S&P; 500 companies last year were equal to nearly 45% of operating earnings--an astoundingly large figure--non-cash charges recorded by just two telecom companies, Nortel and JDS Uniphase, made up almost one-third of the write-off total.

The Nortel and JDS charges were for “goodwill impairment.” Under a change in accounting rules decided before Enron became a household word, companies must immediately write off assets that they know are worth far less than their value on the balance sheet. For Nortel, JDS and others, that has meant writing off goodwill, which essentially is the amount they overpaid for what have turned out to be bad acquisitions made during the boom years.

In aggregate, those goodwill write-offs “could wipe out all [reported] U.S. earnings on the mistakes of just a handful of companies,” Wieting said. Surely, he argues, it wouldn’t make sense to price the market overall based on those bottom-line results.

Most investors must agree, because stock prices, while under pressure again this year, obviously haven’t collapsed across the board. The S&P; 500 is down 5.1% year to date; the Nasdaq composite has fallen 11.6%.

But if corporate accounting now is turning more conservative, it raises the question of what level of earnings growth companies--especially the S&P; 500 firms--can achieve in the next few years.

Grannis, for one, cautions against becoming too pessimistic about earnings potential.

“Profits have come down an awful lot, and lots of restructuring and time have passed under the bridge. There may be some more nasty earnings announcements as companies scramble to come clean, but the overwhelming thrust of corporate efforts going forward will be to cut costs, reduce leverage and restore genuine profitability,” he said.

Investors, however, may only have begun the process of re-evaluating what is “genuine profitability,” and deciding how high a stock price they want to pay for their slice of that profit.

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Tom Petruno can be reached at [email protected]. For recent columns on the Web, go to: www.latimes.com/petruno.