A number of articles have been published recently warning
investors to disregard non-GAAP earnings and focus instead on GAAP
earnings. For example, in yesterday's New York Times, Gretchen
Morgenson, published a piece called "
Earnings, But Without the Bad Stuff
," that highlighted the opinions of Jack Ciesielski, publisher of
Analyst's Accounting Observer
, who makes the case for GAAP.
This issue has received much more attention because of the
strong recovery in corporate profits since the 2008 recession. Many
market analysts have pointed out that corporate profits are at
record levels. Some say that profits probably cannot go much higher
unless revenues begin to rise at a quicker pace. (I agree.)
(click to enlarge)
Source: US Bureau of Economic Analysis and Lark Research
According to the Bureau of Economic Analysis (BEA), the
after-tax profits of U.S. corporations grew at a compounded annual
rate of 8.5% from 1987 to 2012. From 2000 to 2012, the compounded
annual growth rate was 11.4%. As a result, corporate profits as a
percent of nominal GDP increased from 4.1% in 1987 to 10.8% in
2012. Profits have recovered sharply since 2008, even though GDP
growth has been lackluster.
A different picture emerges when we look at the after-tax
reported (i.e. GAAP) profits of the S&P 500. Earnings growth
for these large corporations has not been nearly as great. This is
illustrated in the chart below, which compares S&P 500
as-reported profits (which exclude discontinued operations,
cumulative accounting changes and extraordinary items, as defined
in GAAP.) to the BEA's measure of corporate profits using 1988 as a
(click to enlarge)
Source: BEA, S&P Dow Jones Indices and Lark Research
The comparison here is striking and raises more questions.
According to S&P, as-reported profits of the S&P 500 fell
much more sharply in 2008 and have just recently exceeded their
2006 peak. The decline in U.S. corporate profits, on the other
hand, was not nearly as severe and profits are now well above the
2006 peak. Although their definitions of profits differ, they are
hopefully similar enough to make a comparison relevant. If so and
since the profits of S&P 500 companies are presumably included
in the national figures, most of the difference between the two
should represent profits from publicly-traded small- and mid-cap
corporations and closely-held businesses. It suggests that nearly
all of the growth in U.S. corporate profits have come from
non-large cap businesses, which is a little surprising, since
smaller businesses are believed to be still struggling in the
I have not looked at the GAAP vs. non-GAAP issue as closely as
others (like Mr. Ciesielski), but the following chart highlights
the difference between operating earnings, S&P's proxy for
non-GAAP earnings, and as-reported earnings for the S&P
(click to enlarge)
Source: S&P Dow Jones Indices and Lark Research
The chart above plots the difference between operating and
as-reported earnings as a percentage of as-reported earnings for
the S&P 500. (The definitions of operating and as-reported
earnings are given in this
2002 summary from accountingweb.com
, but S&P Dow Jones Indices should publish up-to-date
definitions on its web site.) The spikes in the chart typically
occur during recessions, such as 1991-1993, 2001-2003 and
2007-2009. (The peak, which is not shown here, was in the 2009
first quarter at 527%.) Thus, the spikes occur primarily as a
result of sharp declines in as-reported earnings. Operating
earnings, which exclude corporate and unusual items, have much
narrower peaks and valleys. That said, it does appear - according
to my imperfect eyeballs - that the difference between operating
and as-reported earnings, excluding the peaks, has been rising for
the past 25 years.
Although S&P's operating earnings is clearly a non-GAAP
measure, it employs a uniform approach that excludes corporate
costs and unusual items that are not seen as recurring. In many
cases, therefore, it may very well differ from each individual
company's definition of adjusted or non-GAAP earnings.
Even using S&P's definition of "as-reported" earnings, it is
difficult to conclude that the market is overvalued. As of October
31, the S&P 500 was trading at 18.5 times as-reported earnings,
below the 25-year average of 24.7 times and median of 19.6 times.
The as-reported P/E for the S&P 500 has ranged between 11.7
times and 122.4 times over that period. There may be other reasons
to think that the market is richly valued, but the S&P is well
within its historical ranges and could conceivably go higher in the
quarters and years ahead.
Although the profits of publicly-traded corporations may not be
quite as high as suggested by the National Income Accounts, the
overall level of profits and especially the differences between
GAAP and non-GAAP earnings should not be taken lightly. Such
comparisons are probably best made on a case-by-case basis or
perhaps by industry sector, however, and not in a macro analysis
across the universe of publicly-traded companies.
In my opinion, it is not that difficult for an experienced
security analyst to identify red flags in a company's financial
reporting. It is also fair to say that most companies have them.
However, it is much more difficult to know whether and when these
potential problems will make a difference to the market.
For example, I believe that any competent housing analyst could
have seen problems developing in the housing market by the year
2000; but it was not until 2006 that those problems became
manifest. In between 2000 and 2006, many housing-related stocks
appreciated at a 40% compounded annual rate.
It is also difficult to say whether red flags will become
headwinds to earnings or lead to an outright collapse. Services
such as those offered by Mr. Ciesielski can help portfolio managers
find turning points and avoid problems, but it is also important to
monitor investments closely.
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
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