By JONATHAN WEIL, Staff
Reporter of THE WALL STREET JOURNAL, August 21, 2001
Few investors know it, but the U.S. stock market today is, by one way of looking at it, the most expensive it has ever been.
How could that be, after the numbing slide since the market peaked in early 2000? It turns out that for all the pain, the stock market now is far out of whack with historical norms by one common measure, the price-to-earnings ratio.
The P/E ratio measures how companies' share prices compare with their profits, showing how much value the market places on each dollar of a company's earnings. The lower the P/E, as a rough rule of thumb, the cheaper the stock. Though this guide to value has lots of exceptions, it remains a venerable market benchmark.
See a quick glossary of accounting terms, both official and unofficial.
See a table and chart illustrating how 10 companies reported their most recent quarterly earnings.
Heard on the Street: Firms Fatten Up Earnings on Accounting Rule Change
The Standard & Poor's 500-stock index of large companies, according to Thomson Financial/First Call, finished last week with an overall P/E ratio of 22.2. While that is well above the long-term historical average of 14.5, it strikes some pros as reasonable in view of factors such as low interest rates and chances for a profit comeback. For instance, Edward Kerschner, chief global market strategist at UBS Warburg, recently called stocks "undervalued on a P/E basis."
But there's a catch. In recent years, P/E ratios have become increasingly polluted. The "E" in P/E used to refer simply to earnings as reported under generally accepted accounting principles, or GAAP. That's what it means when the historical average is cited. But in First Call's figure, the "E" relates to something fuzzier, called "operating earnings." And that can mean just about whatever a company wants it to mean.
Based on earnings as reported under GAAP, the S&P 500 actually finished last week with a P/E ratio of 36.7, according to a Wall Street Journal analysis. That is higher than any other P/E previously recorded for the index. (See details of the calculation.)
This suggests the overall stock market could be further from recovery than many suppose. "I don't think most people realize that the market is as overvalued as it is," says David Blitzer, chief investment strategist at S&P, a unit of McGraw-Hill Cos. "There probably are a lot of people who would sell some stock if they realized how overvalued the numbers are saying the market is."
Why the huge disparity between the two figures given as the market P/E? The answer is that, increasingly, companies are steering investors away from their actual earnings and toward some other numbers. Most common is "operating earnings." Another name for that is "pro forma," or "as if," earnings. Some companies speak instead of their "economic earnings" or "core earnings" or "ongoing earnings."
Such earnings figures typically are higher than net income, because the companies label certain expenses as "special" or "one-time" or "exceptional" or "noncash" -- and leave them out of the calculation.
However, there are no official guidelines for what goes into operating or core or pro forma earnings and what can be left out. Operating earnings and the other terms aren't concepts under GAAP. Nor is there any standard definition for what companies call special or one-time items. The items they cite rarely meet the strict accounting test for "extraordinary items."
Typically, Wall Street analysts go along with the numbers emphasized by the companies they cover. From there, the rosier numbers tend to get repeated throughout the financial-news media, from cable TV to newsletters to Web sites.
More than 300 companies in the S&P 500 now exclude some ordinary expenses, as defined by GAAP, from the operating-earnings numbers they feed to investors and analysts, a Wall Street Journal analysis shows.
In fact, for every dollar of operating earnings S&P 500 companies reported for their most recent three-month periods, 60 cents wouldn't be there if they hadn't excluded costs that are ordinary business expenses under GAAP, according to the Journal's comparison of First Call data with corporate SEC filings and news releases.
The resulting confusion can skew perceptions of value for even relatively sophisticated investors. Novices often are left bewildered.
Take Computer Sciences Corp. The technology consulting company this year has announced a series of charges, covering costs ranging from severance payments to write-offs of software. They totaled $156 million, cutting Computer Sciences' net income for the past four quarters to $184.9 million, or $1.08 a share.
But check its earnings in analysts' research reports and many financial databases, and things don't look nearly so bad. Computer Sciences steered Wall Street analysts to ignore the big expenses, which it dubbed "special items." Looked at in this more favorable way, the company over the past year had operating earnings of $340.9 million, or $2 a share. That would give the stock, which closed Monday at $38.30 a share, a P/E of about 19, making it seem a reasonable value.
And if the special items are included in the earnings? The shares suddenly appear far pricier, with a P/E ratio of about 35.
Sometimes, the results are nothing short of surreal. JDS Uniphase Corp. last month announced that for the fiscal year ended June 30, it had pro forma earnings of $67.4 million. Yet the fiber-optic company actually had a stunning $50.6 billion full-year net loss.
JDS's pro forma earnings excluded 98% of the company's $52 billion of operating expenses. These were mainly write-offs of assets JDS bought for inflated prices during the tech bubble. In explaining its pro forma results, JDS said the charges for those acquired assets "in no way impaired our financial health or strength" because it had bought them with stock instead of cash.
Wall Street analysts almost without exception went along with the company line. The JDS effect is so large that if the company were excluded from the index, the S&P 500's P/E ratio based on GAAP earnings would be more than five points lower, at 31.2, the Journal's analysis shows.
"A lot of companies take their numbers and present them in the best light possible," notes Don Bunnell of West Chester, Ohio, a retired General Electric Co. manager and an active investor. "Most of the analysts can see through this. But most of us lay people can't."
Although companies have long sought to present their results in the best light, the operating-earnings focus has grown so widespread that some market pros fret that Wall Street analysts' earnings measures have lost much of their meaning. "The only thing the consensus agrees on is arbitrary accounting methodologies," says Tom Galvin, chief investment officer at Credit Suisse First Boston,
Companies that stress operating or pro forma earnings say they aren't trying to mislead anyone -- just trying to help people understand their continuing businesses by breaking out items they consider unusual or unimportant. And while those items are usually expenses, companies occasionally also break out certain "one-time" gains from their financial results. Companies also note that investors are free to look at whatever numbers they want and can ignore any nontraditional financial presentation they deem irrelevant.
Historically, pro forma financial statements were used to allow for comparisons of financial results when some extraordinary event, such as a merger, had occurred between the reporting periods. By trying to analyze the performance of two merging companies as if they had been operating together for years, analysts sought to assess future earnings power. With the same goal, they would sometimes exclude expenses or gains they deemed to be nonrecurring.
Over the past decade or so, some industries began designing their own alternative profitability measures. Radio-station operators had "broadcast cash flow." Real-estate investment trusts had "funds from operations."
The practices didn't get out of hand, though, until the start of the Internet boom.
Amazon and Yahoo
Three years ago, for instance, Amazon.com Inc.'s sales were growing at breathtaking rates, but its net losses remained a red flag for some investors. In the second quarter of 1998, Amazon began using new pro forma profitability standards for itself. It was in the red even by those forgiving measures, but the shift made Amazon shares, then trading at 21 times trailing revenue, seem more palatable to investors.
Amazon, which had been buying other companies with its high-priced stock, explained that its quarterly expenses to write down acquired intangible assets -- so-called goodwill -- were so large that they created too much accounting noise for investors to follow.
At First Call, a unit of Toronto-based Thomson Corp., research director Chuck Hill says he first noticed the pro forma trend when Yahoo Inc. began highlighting its own pro forma measures in its financial news release for the fourth quarter of 1998. After that, he says, the floodgates opened. "Once some of these companies realized that people were accepting that, they said, 'Let's push the envelope a little further,' " Mr. Hill says. "It just became an easy way to slide stuff under the rug."
Soon, hundreds of tech companies were excluding other types of regular expenses, such as stock-based compensation and even some payroll taxes, which must be included in net income under GAAP. Many Old Economy companies saw analysts embrace the pro forma numbers and began expanding the boundaries of "special" and "one-time" charges. Today, the practices can be found in companies in nearly every industry.
According to First Call, Honeywell International Inc.'s operating earnings were $2.52 a share during its most recent four quarters, for a "trailing" P/E ratio of 15. That excludes a bevy of charges, such as losses on various customer contracts and expenses from its aborted merger with GE. Honeywell's net income actually was 77 cents a share, producing a far higher P/E of 49.
Office-supplies retailer Staples Inc.'s P/E is 27 based on operating earnings, but 132 based on its net income, which has been dragged down by write-downs of Internet investments.
Corning Inc. trades for 11 times operating earnings. But factor in the fiber company's $4.8 billion of charges last quarter to write off overvalued intangible assets, and Corning has no P/E at all because it has no earnings.
In all of these cases, the more eye-pleasing profit and P/E numbers became the most widely cited ones as the companies trumpeted them in their news releases and conference calls, while downplaying their actual results. Securities analysts, who often are reluctant to pick fights with the companies they cover, simply pass on the same spin to investors. And it's up to investors to evaluate for themselves the earnings and the resulting price-earnings ratios.
To be sure, P/Es are far from a foolproof guide to value. For one thing, stocks in mature, low-growth industries habitually have low P/Es, so that a single-digit P/E on, say, a mining company doesn't necessarily mean it's a bargain. Also, a stock can sport an attractive-looking P/E because of strong earnings over earlier quarters, although its business is about to fall off a cliff.
More confusing still, a company emerging from a loss-ridden period and producing tiny profits may show a very high P/E -- just when its prospects are improving. And in the market as a whole, when corporate profits are poised to rebound after a tough period, stocks could carry relatively high P/E multiples, but this wouldn't necessarily mean it was a poor time to buy.
Once companies' earnings numbers are crunched by analysts, they enter a vast information food chain, where they are repeated, often without explanation, in hundreds of news outlets, including wire services, newspapers, investment newsletters, cable-news channels and financial Web sites. Using a fax service that's free to journalists, but operated by a third-party contractor, First Call distributes lengthy summaries of companies' historical and projected results, not all of which explain the basis for analysts' calculations.
On Yahoo Finance, a free service that's the most heavily used financial Web site, First Call's operating earnings statistics -- including those for Yahoo itself -- are displayed as actual results with no further explanation. A Yahoo spokesman says Yahoo Finance "is currently working to provide better labeling as to whether that information is pro forma or GAAP."
Michael Ching, a telecom-equipment analyst at Merrill Lynch & Co., defends his role in the chain. When Cisco Systems Inc. took a $2.25 billion inventory write-down this spring, Mr. Ching, like virtually every other analyst covering the router maker, abided by the company's wishes and excluded the charge from Cisco's pro forma earnings. Analysts and investors need "a clean number" to look at, Mr. Ching says, adding: "We exclude these one-time elements because they are not predictive about future earnings."
The problem, say accounting specialists, is that the clean numbers may be whitewashed versions of reality. That's because the excluded charges can signal that past profits were overstated. For instance, when companies take big charges to write off assets, this often means they weren't depreciating those assets quickly enough in previous years. And when companies write off bad loans they had made to customers to finance purchases, it can mean the previously recorded sales and profits generated by those loans existed only on paper.
"It's scary," says Douglas Carmichael, an accounting professor at Baruch College in New York. "Since there's no uniformity as to what goes into pro forma earnings, there's no comparability. It's just an undisciplined number that's at the heart of the calculation."
Accounting rules treat layoff-related expenses as a normal part of the business cycle. Analysts who cover Morgan Stanley and Merrill Lynch followed those companies' leads and included their layoff expenses in operating earnings. But analysts who cover Citigroup Inc., Progressive Corp. and Dow Jones & Co., publisher of The Wall Street Journal and the online Journal, excluded their layoff expenses.
Computer Sciences itself has flip-flopped on the issue. It has had many rounds of layoffs over the years. But last fiscal year marked the first time the company classified employee-severance expenses as special charges rather than ordinary expenses. A spokesman says it treated them as special charges because they were made as "part of a global review" of its businesses and because they were so big.
In telecommunications, analysts covering Nortel Networks Corp. submitted earnings estimates to First Call that included the company's second-quarter inventory write-downs. Analysts covering Cisco and JDS Uniphase, however, excluded those companies' inventory charges.
In the financial-services sector, analysts included large investment losses at American Express Co., for example, but excluded them at Wells Fargo & Co.
First Call's Mr. Hill is a longtime critic of aggressive pro forma accounting. But he explains that First Call's mission is to gather and publish consensus earnings targets whose accounting reflects the accepted view of the overall investment community. Whatever accounting method a majority of the analysts covering a stock want to use for their earnings estimates, First Call will use. "Certainly over time, I'd rather listen to the collective wisdom of these analysts than I would some anointed earnings pope," Mr. Hill says. Besides, "they're the only ones that'll give them to us."
To critics such as Mr. Carmichael, analysts employed by Wall Street securities brokerage firms provide anything but an accurate reflection of the broader investment community, given their well-chronicled bullishness and frequently conflicting investment-banking interests. "You're getting a view through rose-colored glasses," he says.
'Earnings Before Bad Stuff'
At the Financial Accounting Standards Board, which sets GAAP, Chairman Edmund Jenkins says he would like to see First Call collect GAAP-based earnings estimates for all the companies it follows. Mr. Hill says that would be nice, but that he would "be shocked if you had any meaningful numbers of contributors."
Securities and Exchange Commission officials also have warned investors not to get suckered by "earnings before bad stuff" news releases. But the SEC says it has little if any authority to clamp down on pro forma calculations in news releases, as long as they are mathematically accurate.
At the same time that pro forma accounting is growing, so is the start of a backlash. One example: Last month analysts who follow real-estate investment trusts for Merrill Lynch, Morgan Stanley and Citigroup's Salomon Smith Barney unit announced they would start focusing more on GAAP and less on those industries' established pro forma metrics.
Many individual investors welcome these small moves. "They shouldn't be afraid to give us a little bad news," says Janice Stonestreet of Overland Park, Kan., who manages her family's portfolio of about 40 stocks with her husband, a retired insurance executive. "I just prefer the facts -- just plain and simple accurate facts."
Write to Jonathan Weil at firstname.lastname@example.org
Here's a quick glossary of accounting terms, both official and unofficial, that companies are commonly using these days to describe their earnings -- or lack thereof.
Operating earnings: This is another name for "pro forma" earnings, in which companies present their financial results "as if" certain ordinary items (usually expenses) didn't exist. Also sometimes called "core income," "economic earnings," "ongoing earnings" or "earnings excluding special items." None of these terms have any particular meaning under GAAP.
Operating income: Sounds like operating earnings, but has a strict definition under GAAP: Revenue less cost of goods sold and related operating expenses stemming from a company's normal business activities. It excludes, for example, interest income and expenses, dividend income, taxes and extraordinary items.
Income from continuing operations: Also sounds like operating earnings, but this, like operating income, has a real meaning under GAAP. It's revenues and expenses stemming from a company's ongoing operations, after taxes. It includes interest income and expenses and other nonoperating gains and losses. It excludes only three things: discontinued operations, cumulative effects of changes in accounting principles, and extraordinary items.
Extraordinary items: This is a real term under GAAP, meaning items that are both unusual in nature and infrequent in occurrence, such as earthquake-related losses in an area where quakes are rare. Extraordinary items count when calculating net income, though not when calculating "income from continuing operations."
Special charges: A term companies use for expenses that are ordinary costs of doing business, but that companies want investors to exclude when valuing their stocks. Also sometimes called "one-time," "unusual" or "exceptional" charges. These terms have no standard definition under GAAP and the items don't meet the GAAP test of an extraordinary item.
Cash flow: A GAAP term meaning cash receipts minus cash disbursements for a given reporting period. It's separated into three categories on a financial statement: cash flow from operating activities, cash flow from financing activities and cash flow from investing activities.
Ebitda: Earnings before interest, taxes, depreciation and amortization. Most companies stick to this definition. But some use the term to refer to earnings figures that exclude not only these expenses, but others as well, such as start-up costs for new ventures and other cash charges. Though often described as cash flow, ebitda isn't the same. For starters, it doesn't necessarily reflect changes in companies' liquidity.
To calculate the price-to-earnings ratio for the Standard & Poor's 500-stock index, The Wall Street Journal divided the combined market capitalization of the 500 companies currently in the index by their most recently reported four quarters of earnings. These earnings exclude only items classified under generally accepted accounting principles as extraordinary items, discontinued operations or cumulative effects of changes in accounting principles.
This methodology differs slightly from the one used by S&P, which updates earnings statistics for the index just once a quarter. S&P doesn't revise earnings from previously reported quarters to account for additions or deletions to the index. And it historically hasn't revised previously reported earnings to account for companies' financial restatements. The Journal's calculations show a trailing P/E of 36.7 as of Friday. S&P may report a somewhat lower P/E ratio when it releases its second-quarter earnings tally, depending on how it handles JDS Uniphase. JDS has announced a $50.6 billion loss for its fiscal year ended June 30. But JDS said it would restate results for the March 31 quarter so that most of the loss appears in that quarter, not in the June quarter. S&P has been considering revising its first-quarter earnings figures to reflect JDS's restated losses, but hasn't announced a decision.
The Journal used data from Multex.com Inc. as well as companies' news releases and filings with the Securities and Exchange Commission. The P/E ratios in the Journal's daily stock-price tables are calculated using trailing earnings, excluding extraordinary items, accounting changes and discontinued operations.