If 25 percent of earnings are “fictitious” then investors are paying much more for stocks than they think and forward-looking prospects for the equity market are indeed poor.
In contrast, I do not believe that the overall earnings data that companies report materially misrepresent the profitability of the great majority of firms. There are biases that work in both directions, as I will show later in this chapter. If one is careful, earnings data do point in the right direction.
But in a nod to the skeptics, investors should indeed scrutinize earnings, particularly from firms that issue employee stock options or have large pension obligations. Standard & Poor’s has made that scrutiny easier with its calculation of core earnings, a new earnings concept that I applaud and will also discuss later in this chapter. Examination of S&P core earnings reveals that employee stock options are concentrated in technology firms, while pension obligations are mainly found in older industrial firms, such as automobiles, airlines, and some energy companies.
Earnings Concepts
Earnings, which is sometimes called net income or profits, is simply the difference between revenues and costs. But the determination of earnings is not just a “cash in minus cash out” calculation, since many costs and revenues, such as capital expenditures, depreciation, and contracts for future delivery, extend over many years. Furthermore, some expenses and revenues are one-time or extraordinary items, such as capital gains and losses or major restructurings that do not give a good picture of the ongoing or sustainable earnings that are so important in valuing a firm. Because of these issues, there is no single “right” concept of earnings.
There are two principal ways that firms report their earnings. Net income or reported earnings are those earnings sanctioned by the FASB, an organization established in 1973 to establish accounting standards. These standards are called generally acceptable accounting principles or GAAP accounting. These are the earnings that appear in the annual report and are filed with government agencies.2
The other, more generous, concept of earnings is called operating earnings. Operating earnings represent ongoing revenues and expenses, omitting unusual items that occur on a one-time basis. For example, operating earnings often exclude restructuring charges (e.g., expenses associated with a firm closing a plant or selling a division), investment gains and losses, inventory write-offs, expenses associated with mergers and spin-offs, and depreciation of goodwill, among others.
Operating earnings are what Wall Street watches and what analysts forecast. The difference between the operating earnings the firm reports and what analysts expect them to report drives stocks during the “earning season,” which occurs in the few weeks following the end of each quarter. When we hear that XYZ Corporation “beat the Street,” it invariably means that its earnings came in above the average (or consensus) forecast of operating earnings.
In theory, operating earnings give a more accurate assessment of the long-term sustainable profits of a firm than reported earnings does. But the concept of operating earnings is not formally defined by the accounting profession, and its calculation involves much management discretion. As management has come under increasing pressure to beat the Street’s earnings forecasts, they are motivated to “push the envelope” and exclude more expenses (or include more revenues) than are appropriate.
The data show the increased gap between reported and operating earnings in recent years. From 1970 to 1990, reported earnings averaged only 2 percent below operating earnings. Since 1991, the average difference between operating and reported earnings has widened to over 18 percent, nine times the previous average.3 In 2002 the gap between the two earnings concepts widened to a record 67 percent.
During the latter phases of the bull market of the 1990s, some firms, particularly those in the technology sector, were rightly criticized for excluding too many expenses. For example, Cisco Systems wrote off inventories that the firm couldn’t sell and used highly favorable accounting techniques to make acquisitions appear far more favorable than they were.
Some firms advanced earnings concepts that involved even more extreme assumptions. Amazon.com declared it was profitable in 2000 on a pro forma basis if the interest on nearly $2 billion of debt was ignored. This is like saying my vacation home doesn’t cost me anything as long as I ignore my mortgage payments. Clearly standards had to be tightened.
The Employee Stock Option Controversy
One of the most controversial issues is accounting for employee stock options. In the last chapter we spoke of the options culture that technology firms, particularly Microsoft, fostered in the 1980s and 1990s. Employee stock options gave workers a right to buy stock at a given price if they worked for the firm for a given period of time. As I noted in Chapter 9, the proliferation of management stock options began after the IRS ruled that payment by options did not violate the compensation limitations set by Congress.
We have already showed that management stock options discourage dividends. But there was yet another reason why stock options became so popular. Not only did they bypass certain restrictions on management compensation, but most stock options, when granted, did not have to be accounted for as an expense in the firm’s profit statements. Instead options were expensed if and when these options were exercised, which may be years after they are granted.
This convention, vigorously supported by technology firms, was allowed by the rules established years ago by the FASB. The board’s position on options generated much debate within both the academic and professional communities. In 2000 the FASB reversed its position and, following the lead of the International Accounting Standards Board, decided that options should be expensed when granted. In 2004, expensing options would lower S&P 500 earnings by 5 percent, but earnings of the optionladen technology sector would fall substantially.
Technology firms lobbied Congress to block the FASB from instituting those rules. In one of the more shameful incidents of congressional meddling, Senator Joseph Lieberman of Connecticut led the Senate in 1993 to an 88–9 nonbinding “sense of the Senate” resolution disapproving FASB’s proposal. After this vote, the FASB backed down on its proposed rule change.
But after the technology bubble broke, the FASB revisited the issue and set 2005 as the year that firms must expense options. As of this writing, technology firms are still seeking congressional help to block this rule.
Why Stock Options Should Be Expensed
On this issue, the FASB is right and the technology industry and the politicians that support them are wrong. Nobody put the case for expensing options better than Warren Buffett, who stated in his 1992 annual report well before this issue took center stage: “If stock options are not a form of compensation, what are they? If compensation is not an expense, what is it? And if expenses shouldn’t go into the income statement, where in the world should they go?”4
Options should be expensed when issued because earnings should reflect the firm’s best determination of the sustainable flow of profits—profits that could be paid out as dividends to shareholders. If employees were not issued options, their regular cash compensation would have to be raised by the value of the options forgone. Whether the compensation is paid by cash, options, or in candy bars, it represents an expense to the firm.
When an option is exercised, the firm sells new shares to the option holder at a discounted price determined by the terms of the option. These new shares will reduce the per-share earnings and is called the dilution of earnings. Current shareholders are giving up part of the firm’s profits to new shareholders who, through options, purchased the shares at below-market prices.
CRITICS OF OPTION EXPENSING
Some argue that options should not be expensed if management repurchases sufficient shares in the open market to offset the new shares issued when options are exercised. In this case there will be no dilution. But this argument ignores that fact that the funds used to buy back shares could have been distributed to shareholders or otherwise used to en
hance shareholder value.
Critics of expensing also ask what happens if the option is expensed and then the stock price goes down and the option is never exercised. In that case the option expense would be reversed and be counted as a one-time or extraordinary gain. On the other hand, if the stock price goes up and the option is exercised for more than the expense recorded at the time of issuance, then the firm should take an additional extraordinary expense.
Critics also maintain that employee options cannot be properly valued. This is fallacious. Modern option pricing models can value options as well as, if not better than, the thousands of other estimates that go into an income statement, such as the useful life of capital expenditures, the market value of illiquid assets, or the write-down of intangible assets.
RISKS TO STOCKHOLDERS
There is a favorable side of options. The issuance of employee stock options reduces the risk borne by shareholders. If the firm experiences poor earnings and the share price declines, then the options will expire worthless and the firm, if it had expensed them, would realize a gain by reversing the expense. On the other hand, if there is good news and the share price rises, then the option will be exercised and per share earnings will decline because of the dilution.
The risk that employees shoulder when they accept options instead of cash compensation reduces the risk to the outside shareholders. This means that a firm that fully expenses the fair value of options paid to employees should, all other things being equal, be valued slightly more than firms that pay an equivalent amount of cash in lieu of options.
But this also means that much of the upside of many technology stocks that heavily issue employee stock options is enjoyed first by the employees, not the outside shareholders. This is an important consideration not always appreciated by those buying stocks in this option-saturated sector.
FIRMS EXPENSING OPTIONS
As of mid-2004, 176 firms in the S&P 500, representing over 40 percent of the market capitalization, have decided to expense options.5 Coca-Cola was one of the first large firms to eliminate its employee stock plan. Microsoft terminated its employee stock option plan in 2003, substituting stock grants for dividends.
Might Warren Buffett’s influence have a bearing on these cases? Buffett is a major stockholder of Coca-Cola and has struck up a close friendship with Bill Gates, chairman of Microsoft. Whatever the reason, the tide of professional opinion is clearly moving toward expensing as the FASB proposes.
Employees do not need options to motivate them to work for tech firms. Clearly in the 1990s workers thought options were the guaranteed road to riches. But the decline in the market has shattered many of those dreams. For employees, accepting options in lieu of cash is like accepting pay in lottery tickets. When they saw others winning, it looked like a good idea. But in the long run, these options are a risk that many employees can ill afford.
Controversies in Accounting for Pension Costs
DEFINED-BENEFIT AND DEFINED-CONTRIBUTION PLANS
Almost as contentious as the treatment of options is the accounting treatment of pension costs. There are two major types of pension plans: defined-benefit (DB) plans and defined-contribution (DC) plans.
Defined-contribution plans, which gained enormous popularity in the 1990s bull market, place both the employee’s and employer’s pension contributions directly into assets that are owned by the employees. In these plans, the firm does not guarantee any benefits. In contrast, in defined-benefit plans the employer spells out the income and health care benefits that will be paid and the assets backing these plans are not chosen by or directly owned by individual employees.
Under government regulations, DB plans must be funded. This means the firm must place aside assets that will cover the expected benefits associated with these plans. In contrast, in DC plans, the risk that the value of the plan at retirement will not cover retirement expenses is taken by the employees, and they must decide where to place their investment dollars.
There were two reasons for the tremendous increase in the popularity of the defined-contribution plans over the past two decades. One was the great bull market of the 1990s that made many employees believe that they could obtain a better return on their own investments than the benfits promised by the firm.
But a second reason was that contributions in a DC plan were immediately vested, that is, became the property of the employee. If an employee left the firm, he could take his 401(k) assets with him to another job. In contrast, it normally takes a number of years before the benefits of a DB plan belong to the employee. If an employee left the firm before these benefits became vested, then no benefits would be received.
PROBLEM AND RISKS IN DEFINED BENEFIT PLANS
Current rules for calculating the returns on the assets backing defined benefit plans are generous to the corporations. FASB allows firms to choose their own estimate of the rate of return on the assets in their portfolio, and often these estimates are too high. These estimated returns are credited to income whether they are earned or not. Furthermore, if the value of the assets falls below the pension liabilities (and the fund is called underfunded), FASB allows firms to close this gap over a substantial period of time.
While the government requires firms to build a fund for retirement income benefits, it does not require them to fund for other pension-related benefits, particularly health benefits. In 2003 a Goldman Sachs analyst estimated the health care liabilities of the three Detroit automakers at $92 billion, roughly 50 percent greater than their combined market capitalizations.6
Most investors are fully cognizant of these unfunded liabilities and have taken down the value of the auto manufacturers, as well as that of other firms with large underfunded pension plans. In March 2003, the twenty-five companies identified as having the most serious pension-funding issues comprised only 1.4 percent of the market value of the S&P 500. The bankruptcies of the steel manufacturers and airlines over the last decade are related to their pension obligations.
Since virtually all pension plans started in the last twenty years are defined-contribution plans, the corporate pension problem will disappear over time as the risk of funding retirement is shifted to individuals instead of corporations. Nevertheless, it behooves investors to take a close look at the stock of firms with large defined-benefit plans, as they can be a serious claim on future earnings.
Standard & Poor’s Core Earnings
The dismay over the treatment of pension and options and the ever-widening definition of operating earnings led Standard & Poor’s in 2001 to propose a uniform method of calculating earnings that they called core earnings. The objective was to define and measure earnings from a firm’s principal or core businesses and to exclude from earnings revenues or expenses that are incurred for other reasons. Core earnings expenses employee stock options, recalculates pension costs, and excludes unrelated capital gains and losses, goodwill impairments, and one-time litigations gains and losses, among others.
One cannot underestimate the importance of finding a good measure of sustainable earnings. A typical firm in today’s market sells for about twenty times yearly earnings. This means that only 5 percent of its price depends on what happens in the next twelve months, and 95 percent of its price depends on what happens after that. That is why when we calculate earnings, accounting decisions should distinguish between any one-time gains and losses that are not expected to be repeated and those that have implications for future profitability. This goal led Standard and Poor’s to develop core earnings.
This was an unusual and bold stance taken by a nonregulatory, private-sector firm that is the keeper of the world’s most replicated benchmark, the S&P 500 Index. The New York Times called core earnings one of the best ideas in 2002.7 Warren Buffett applauded S&P’s stance, stating in an open letter, “Your move is both courageous and correct. In the future, investors will look back at your action as a milestone event.”8
I also strongly support core earnings and applaud the work don
e by David Blitzer, managing director and chairman of the Index Committee, Robert Friedman, Howard Silverblatt, and others. Although I quibble with their estimation of pension costs (a notoriously difficult accounting issue), I believe core earnings makes a significant move in the direction of standardizing profit statements and is a very good way to measure a firm’s profitability.
Earnings Quality
Can a better read on earnings quality be profitable to investors? Most certainly. One way to measure the quality of earnings is by examining a firm’s accruals, which is defined as accounting earnings minus cash flows.
A firm with high accruals may be manipulating its earnings and this could be a warning of future problems. Alternatively, a firm that has low accruals may be a sign that earnings are being conservatively estimated.
Richard Sloan, a professor at the University of Michigan, determined that a high level of accruals was related to subsequent low stock returns.9 Sloan found that from 1962 through 2001, the difference between the returns to firms with the highest quality earnings (lowest accruals) and the poorest quality earnings (highest accruals) was a staggering 18 percent per year. Further research indicated that despite the importance of accruals, Wall Street analysts did not take this into account when forecasting future earnings growth.10
Determining earnings will always be fraught with estimates, even if made in good faith. That is why cash flows, as well as dividends, are objective measures of firm profitability that must supplement earnings data.
The Future for Investors Page 17
