When Picking Stocks, Quality of Earnings Matters
A Look Back at the Quality of Earnings Problem
Back in 1987, Thornton L. O’Glove published a book entitled Quality of Earnings, The Investor’s Guide to How Much Money a Company is Really Making.
In this book, the author shows how companies use alternative yet accepted accounting practices (GAAP) to report completely different levels of profitability. In particular, he illustrates a chart published by the late accounting firm Arthur Andersen & Co. This chart, entitled “Accounting Magic” shows how accounting assumptions can be used to more than double a company’s profitability without changing the economics of its business.
Corporate and Wall Street Incentives Create an Environment of Caveat Emptor for Buyers
Specifically, Thornton O’Glove showed how to improve a company’s reported earnings from $0.80 to $1.79 per share by legally altering six accounting assumptions. This gives the illusion of greater profitability and value to the investment community. As a comparison, a company reporting only $0.80 per share and trading at $20 on the stock exchange has a price-to-earnings multiple (P/E) of 25 and an earnings yield (E/P) of 4%. However, using more favorable accounting assumptions to alter the earnings to $1.79 per share, the P/E and earnings yield improves to 11.2 and 8.95%, respectively. Although nothing has changed economically, the latter reporting appears more attractive to investors and will generate bigger bonuses for corporate executives and for Wall Street. Ultimately, it generates Caveat Emptor for investors.
The Regulatory Backdrop and Complexity of Financial Reporting
Aren’t we protected by the SEC and Financial Accounting Standards Board (FASB)? Yes. However, there’s a lot of wiggle room due to the complex and subjective nature of financial reporting. While the financial reporting rules have changed since 1987 to address abuses, the process has become more complex and subjective, requiring increased documentation and deeper analysis. This doesn’t bode well for the average investor trying to put together a retirement portfolio.
How Price and Value Looks for Today’s Stock Market Buyer
We wanted to see if anything has improved since 1987. Hence, we analyzed a database of publicly traded companies each worth over $10 billion. For each company, we compared its GAAP earnings to economic earnings. What we found was astonishing. Using the New Constructs, LLC database, we reviewed over 600 companies with an aggregate market value of $33 trillion. These companies had a total trailing 12-month GAAP earnings of $1.4 trillion but an economic earnings of only $258 billion.
This wide spread difference between GAAP and economic earnings distorts company valuation. On one hand, the GAAP-based P/E ratio of 23.7 suggests expensive but reasonable valuation. On the other hand, the economic earnings-based P/E ratio of 128.1 is outrageously expensive. Overall, 32 companies had a true economic P/E ratio below 20. Among those 32 , only 12 had economic earnings equal-to or greater-than GAAP earnings.
This example isn’t intended to identify 12 stocks to put into your portfolio. Rather, it illustrates that a lot of smoke and mirrors goes into financial reporting. Ultimately, you need to do your homework to understand the true economics behind businesses. It will help you find great companies at reasonable prices and that is how you make money in the long run. This is what we do here at QMI Capital. Until next time.