BARRON'S: Economic Beat

A Better Way To Gauge Corporate Profitability

By David Blitzer and David Wyss

Creative accounting is being blamed for the stock market's recent plunge.

Although, as Federal Reserve Chairman Alan Greenspan stated in his recent

congressional testimony, corporations are coming clean, earnings are shrinking

in the wash water. More important, investors still aren't sure whether to trust

even the new, lower numbers being reported.

Restoring confidence in companies is critical for the stock market and, in the

longer run, the economy. The U.S. has long prided itself on the transparency of

its corporate structure. The shareholders of a corporation are its owners,

entitled to know everything necessary to evaluate it and its management.

Shareholders no longer feel they have such information. And if shareholders are

required to buy stocks without understanding a company's fundamentals, they may

offer much lower prices.

Cleaning up corporate accounts requires a clear definition of what the

accounts should be, as well as strict adherence to accounting principles. Both

issues must be dealt with decisively to restore confidence.

Historically, the U.S. has had rule-based accounting standards, while Europe's

were based on the principle of full disclosure. Both have their problems, but

it's the American version that is currently under attack. Some corporations have

used the rules to violate the spirit of accurate accounting. Others have

stretched the rules to do the same. The loopholes must be plugged.

The other problem has been that "as reported," or "GAAP," profits were

increasingly seen as irrelevant to companies' long-term future. Mergers and

acquisitions create one-time charges that should be considered differently from

ongoing costs. To address these issues, companies reported "pro forma" or

operating earnings, and Wall Street stock analysts produced their own versions.

Used and defined correctly, all three definitions are useful. The major

differences:

-- As-Reported Earnings: These include all charges, except for those from

discontinued operations and some extraordinary items, as defined by generally

accepted accounting principles (GAAP).

-- Operating Earnings: These are reported earnings, but with some one-time and

corporate charges reversed. Unfortunately, each Wall Street analyst has his own

definition of what can be excluded, so comparing forecasts and analyses based on

operating earnings is extremely difficult.

-- Pro Forma Earnings: Originally, these were earnings adjusted for

acquisitions or deacquisitions, so that the data could be analyzed "as if" the

transactions hadn't occurred. However, the definition has been broadened so that

it can hide almost anything and has become useless or misleading. Our personal

limit was reached when we read seven different definitions of pro forma earnings

in one annual report.

Our employer, Standard and Poor's, has taken the lead in proposing the use of

core earnings, which focus on a company's ongoing operations. They include all

the revenues and costs associated with these operations, but exclude all

revenues and costs not so related, including hedging operations, litigation

settlements, merger expenses and costs relating to financing. These costs may be

significant, but they aren't part of a corporation's core profitability.

Core earnings include the expense of employee stock options, restructuring

charges from ongoing operations, writedowns of depreciable or amortizable

operating assets, pension costs and expenses linked to purchased research and

development services.

Core earnings exclude goodwill impariment charges, gains or losses from asset

sales, unrealized gains or losses from hedging, pension gains, expenses related

to mergers and acquisitions and proceeds from litigation and insurance

settlements.

Although no single definition is perfect, we believe that core earnings

provide the clearest possible definition, allowing meaningful comparisons across

time and across companies. And many firms and analysts are beginning to move

toward this definition in their reports.

Arguments against the core earnings concept usually center on one of the

following:

-- Options: The contention by some critics that options can't be priced is

silly; they're priced every day on Wall Street, and the theory and practice is

much clearer than for most other accruals on the balance sheet. They may not be

priced easily for small firms whose shares don't trade much, but this definition

isn't really meant for such companies.

Some critics argue that the issuer shouldn't accrue costs until the options

are exercised. That would certainly be better than companies' current practice

of pretending that options have no value. However, recognizing the expense only

when a recipient exercises would subject a company to earnings volatility

completely beyond its control.

We don't believe, by the way, that options are bad. On the contrary, we

believe they're useful in aligning the interests of managers and shareholders.

However, they are costs just like salaries, benefits and other forms of

compensation.

-- Restructuring Charges: Restructuring an ongoing operation is part of the

normal cost of doing business. A company can't restructure every quarter and

call the costs one-time charges.

-- Pension Costs and Earnings: Pensions, like wages and health-care

expenditures, are part of the cost of hiring workers.

Contributions to a pension fund are part of the cost of running a company.

Earnings of the pension fund aren't, however, part of the company's core

business. Pension-fund gains aren't normally available to the corporation's

shareholders, except in the rare instance when an overfunded plan is terminated.

The corporation will benefit as future contributions are reduced by the plan

gains, but can't claim those gains when they are earned.

Solving the Problems

As Greenspan stated in his testimony, the economy is doing better than

expected. However, the stock market has fallen into another slump, after

apparently recovering from the Sept. 11 trauma. Why has the market disconnected

from the economy? There are four major reasons:

1. The market was overvalued in early 2000, as irrational exuberance reached

new extremes.

2. Corporate earnings, squeezed by excess world capacity and hurt by the

strong dollar, plunged 50% from 2000 to 2001.

3. The world has become riskier, as threats of terrorist attacks and war in

the Middle East increase the risk premium demanded.

4. Creative accounting has made investors uncertain of what the bottom line

is, or whether to trust it.

How to apportion blame among these explanations is unclear, but most of the

problems are being fixed.

The overvaluation is rapidly disappearing. The S&P 500's price-earnings ratio,

based on its expected 2003 as-reported earnings of $45, is 18.8. That compares

with 22.4 on the trailing 12-month as-reported earnings of $37.80. Moreover,

first-quarter earnings in 2002 equaled those in 2001, and earnings are turning

up.

The model favored by the Federal Reserve (the market's P/E ratio equals the

inverse of the bond yield) implies that a price-earnings ratio of 21 is

warranted. So, stocks are near appropriate levels.

The dollar is coming down fast, which should permit fatter profit margins. The

economic growth in the U..S. and Asia is gradually whittling away excess

capacity. We don't expect to regain the 2000 earnings level until 2004, but

earnings are moving back upward.

The increase in perceived risk is something we probably have to live with. The

world is probably safer now, since security measures have been stepped up after

Sept. 11. However, we aren't as safe as we thought we were.

Even without the corporate accounting scandals, the market would have

corrected. But even if the accounting scandals are fixed, returns over the

coming years won't match the amazing performance of the 1982-1999 period, when

the S&P 500 returned an average 18% a year.

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