Mistrust "Operating Earnings"

As the new year begins, as investors focus on how 2008 will unfold, and as sell-side analysts frantically mark down their earnings estimates for the year as the recession takes hold, investors shift their focus to growth and valuations for this year. 

From a macro perspective, investors usually focus on what Wall Street calls "operating earnings."  In the nomenclature, "operating earnings" are earnings before extraordinary charges.  Ironically, the largest extraordinary charges in 2008 will be generated by Wall Street itself as the banks and brokers compete to see who can charge off the biggest amounts arising from submerging prime and other lousy credit investments. 

The bulls argue investors should not focus on extraordinary charges because they do not represent future profitability.  Instead, investors should focus on profits generated from ongoing operations.

They are wrong.  Or at least misguided.  What matters is reported earnings, not operating earnings. 

Why?  Because operating earnings over-estimate true corporate profitability.

If you listen to the bulls who say you should buy stocks now, they argue that the market is trading at 13.5x earnings, the cheapest valuation in awhile.

Is it? 

This argument is predicated on the market trading off operating earnings.  According to Standard and Poor's, analysts expect market operating earnings to be $101.24 this year, giving the market a forward PE of 13.6x.  However, on a reported basis, strategists are expecting reported earnings of $83.70, giving the market a multiple of 16.5x.  When using reported earnings, the market is not so cheap. 

Using operating earnings would make more sense if operating earnings and reported earnings roughly equaled over time.  However, this is not the case.  Operating earnings consistently overestimates actual corporate profitability.  Thus, the price/earnings multiple of the market using operating earnings is consistently lower than the PE using reported earnings.

In the 79 quarterly earnings provided by Standard and Poor's (including Q4/07), only nine times has reported earnings been greater than operating earnings.  Not since 1995 has there been a quarter when operating earnings were lower than reported earnings. 

The quarterly variation between operating earnings and reported earnings has averaged 15.6%. (Excluding the collapse of the tech/media/telecom bubble of 2000-2002, the average variation has been 10.6%.)  In other words, operating earnings on average has been more than 15% higher than reported earnings. 

These variations effect market multiples.  Since Q4 1988, the average trailing PE has been 19.3x using rolling 12-month operating earnings and 22.6x using reported earnings.  Thus, operating earnings have substantially underestimated the true PE of the market. 

There are three reasons why operating earnings are used rather than reported earnings, two practical and one intellectually flawed.

The first and most practical reason is that charge-offs cannot be forecasted.  Charge-offs are random.  Forecasting a random event with any precision is impossible.  Operating earnings can be forecasted with some level of confidence.  Thus, investors focus on what can be modeled.  In my opinion, this is the most valid reason to use operating earnings rather than reported earnings.

Another reason why operating earnings are utilized is because reported earnings are more volatile.  Charges occasionally are very large, which distorts true profitability, making valuations based on a specific points in time not particularly useful. 

However, one can mitigate the effects of volatility by smoothing charges over time by applying an average charge-off to approximate reported earnings. A discount based on historical averages will dampen estimated earnings during booms but present a more accurate portrait of profitability during busts.

The final rationale for using operating earnings is because for most companies, charge-offs are one-time in nature.  The general practice of analysts is to ignore one-time charge-offs when forecasting future profitability.  For serial chargers - those companies that take extraordinary charges fairly regularly - analysts will often make an approximation for charge-offs when modeling future earnings estimates.  However, relatively few companies are serial chargers.  Thus, since most companies are not serial chargers and most charge-offs are one-time in nature, this standard should be applied at the macro level because they represent an aggregation of charge-offs that are, for the most part, one-time in nature.

This is wrong.

The reason why the stock market, or any capital market, exists is to channel savers' capital into profitable investments.  When capital is committed to shareholders equity, a risk-adjusted return is required.  If the profits from equity investments in aggregate are too low, capital will flow away from equities to other opportunities.

Included in expenses before profits are maintenance capital costs, generally known as "depreciation."  Assets depreciate over time.  Money must be spent to reinvest in depreciated capital. Otherwise the company will lose profit-generating capacity.

If capital is mis-allocated within the business, assets required to generate expected profits deteriorate, and at some point, the company will have to take a charge to account for unproductive capital allocation.  This charge represents an expense to shareholders as it represents assets that no longer have productive value.  The expense is similar to depreciation, which is expensed against income as it is incurred.  Such an extraordinary charge is merely deferred depreciation taken all at once instead of over the life of the asset.  And since, in aggregate, investors do not exclude depreciation from their earnings estimates, investors should not exclude extraordinary charges to write down unproductive assets.

Charge-offs also include write-offs for mergers and acquisitions.  The rationale for not including M&A charge-offs is that the merger has already occurred and the synergies did not accrue as expected, so the charges represent a cost that is unlikely to be repeated in the future.

Again, the question comes to capital allocation.  The company did not have to merge or buy another company.  Management chose to allocate capital in such a manner rather than allocate capital more judiciously. 

The argument would have merit if, in aggregate, companies stopped making dumb acquisitions.  However, there is no evidence that corporations have stopped making dumb purchases, given that supposedly the best and brightest Ivy League graduates were busy buying submergingprime mortgage originators for billions of dollars months before the market began collapsing.  Morgan Stanley, Merrill Lynch et. al. could have taken their capital and given it back to shareholders rather than buying entities that are now worth zero.  (If The Masters of the Universe had taken half the money they wrote-off buying this garbage and burned the money in a bonfire on Wall Street then put the other half in the bank, this would have been more of a value-creating event than getting waste-deep in the garbage that facilitated an asset market so overheated that even those of us in the sticks could clearly see the endgame.)  If the highest paid guys on the planet are taking charges doing stupid things, then periodic write-offs to take the proverbial baths are relevant to aggregate profitability because they will certainly occur again in the future.

This does not mean one should ignore operating earnings entirely.  Using operating earnings to value stocks does provide some informational content, as do all valuation metrics, such as price/book, price/sales, price/free cash flow, enterprise value/EBITDA, price/free cash flow, etc.  But all have their flaws.  Thus, it is best to use several metrics to determine if the market is cheap or not.

Investors must be aware of the weaknesses when using operating earnings to value the market.  Using operating earnings over-estimates corporate profitability and under-estimates market valuation. 

A more accurate measure of long-term corporate profitability would be to apply a discount to operating earnings.  Historically, reported earnings have been 10%-15% lower than operating earnings.  Thus, applying a 10%-15% haircut to operating earnings would more accurately measure true longer-term corporate profitability, and thus give investors a better read on market valuation.

Edited.  Thanks for catching that mistake, psychodave.

Comments

[psychodave]

"analysts expect market operating earnings to be $101.24 this year"
errmm . . . 100.32, I just got the iee500_gics.xls as of "1/14/08" this a.m.
A part of this optimistic number is that 2H07 to 2H08 growth of the Financial Sector Op. earnings will be (you'd better sit down and put your coffee cup somewhere safe now) just shy of 139%. Oh, and Op. earnings on Consumer Discretionary will grow over 40%.

"In the nomenclature, "operating earnings" are earnings before extraordinary charges"
Am I mistaken to think that Operating Earnings are also before taxes? Please reply.

"Operating earnings consistently underestimates actual corporate profitability"
Your persuasive and thorough presentation influences me to suggest you meant "over"estimate, not "under"estimate. Also, note the 3rd-person plural verb form, not the 3rd-person singular, in this redaction. It is due to my whimsical notion that the noun "earnings" is a plural form.

Thanks for your very helpful "an extraordinary charge is merely deferred depreciation taken all at once".

"However, there is no evidence that corporations have stopped making dumb purchases"
I blame management, as opposed to the lads on the loading dock at the back. Corporations are kind of inanimate. Management always reminds me of Bullwinkle assuring Rocky that, this time for sure, he'll pull a rabbit outta the hat. Especially when they, like Citicorp yesterday, allege that they are returning capital to shareholders when they buy back stock shares.

"A more accurate measure of long-term corporate profitability would be to apply a discount to operating earnings"
No question. Thanks again. But, does the stock market look for prudent long-term profitability, or does it look for the closest pile of cash it can plunder, regardless of consequences? Color me "confused".

[Toro]

Dave

Thanks for pointing out my mistype. That's what happens when you're editing at 11:30pm. lol

Operating earnings are after taxes.

On whether or not the market looks for long-term profitability or the closest pile of cash to plunder, I would answer that question "Yes."

[enjoyingmylife]

Toro, superb blog you've got here; greatly enjoy your commentary. I've been lurking for a while and am holding SRS and GLD in part from reading your posts (don't worry, not holding you to any of this stuff).

Curious what you think of SRS today (was below 127 at one point)? Simply retrenchment after being overbought? Motivated seller?

[enjoyingmylife]

Ahh, probably the beige book coming out less weak than anticipated. If so, probably means more good buying opps....hopefully not that we're wrong.

[Toro]

Thanks enjoyingmylife.

I already own the ETF and I'm a buyer of the SRS in the $100-$110 range. If I didn't already own a chunk, I would be buying a position on an upswing in the market. I'm bearish on the market, and the incremental news is going to get worse. REITs aren't stupidly over-valued as they were several months ago, but they aren't cheap enough to protect an investor from a continued bear market.

T.

[psychodave]

Thanks for responding to my Op. Earnings question.

I'm having trouble reconciling your "Operating earnings are after taxes" with this Wikipedia entry:

http://en.wikipedia.org/wiki/Income_statement#Earnings_per_share
(see the "Complex example")

I've benefited a lot from your patience and helpful answers in the past. Not trying to quibble or carp, just trying to avoid fundamental errors.
Thx.

[Toro]

No problem Dave

Yeah, I see where you are coming from. From an accounting perspective, you are absolutely correct. From a Wall Street analyst perspective, "operating earnings" means excluding charges.

T.

[enjoyingmylife]

Toro,

Holy SRS! From 140+ Friday (where I luckily got out) to below 107 in two days! Curious, you still buying at this level, or has your target/opportunity calc changed?

[Toro]

I think the REITs have a bit more to run but I do plan on re-loading the shorts I liquidated earlier this month. The bear market has not ended.

T.

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