VARIOUS EARNINGS MEASURES

VARIOUS EARNINGS MEASURES

A commonly used measure of a company’s performance over a period of time is its earnings, which is often stated in terms of a return—earnings scaled by the amount of the investment. But earnings can really mean many different things depending on the context. If a financial analyst is

FINANCIAL STATEMENT ANALYSIS

evaluating the performance of a company’s operations, the focus is on the operating earnings of the company—its earnings before interest and taxes, EBIT. If the analyst is evaluating the performance of a company overall, the focus is upon net income, which is essentially EBIT less interest and taxes. If the analyst is evaluating the performance of the company from a common shareholder’s perspective, the earnings are the earnings available to common shareholders—EBIT less interest, taxes, and preferred stock dividends. Muddying the financial waters further is the issue of nonrecurring earnings or losses. Should the analyst focus on earnings before nonrecurring items or after? Therefore, it is useful to be very specific in the meaning of “earnings.”

CAN EARNINGS BE MANAGED? As we discussed in Chapter 3, there is a possibility that reported finan-

cial information may be managed or manipulated by the judicious choice of accounting methods and timing. In particular, earnings can be manipulated using a number of devices, including the selection of inven- tory method (e.g., FIFO versus LIFO) and the selection of depreciation method and lives. The possibility of manipulation exists, so the burden is on the financial analyst to understand a company’s financial report- ing, accounting methods, and the likelihood of manipulation.

There are many pressures that a company may face that affect the likelihood of manipulation. These pressures include:

■ Executive compensation based on earnings targets. ■ Reporting ever-increasing earnings, especially when the business is sub-

ject to variations in the business cycle. ■ Meeting or beating analyst forecasts.

Earnings targets comes in various forms, but typically schemes on earnings targets provide for a bonus if earnings meet or exceed a speci- fied target such as a return on equity. Disney, for example, provides cash bonuses based on adjusted net income. 1

One-sided incentives such as this—rewards for beating the target return, but no penalty for not making the target—create problematic situations. If, for example, management knows that the earnings target

1 For many years, Disney paid Michael Eisner a bonus equal to 2% of the difference between the actual net income and that net income that produces an 11% return on

equity. Currently, however, the target returns are not disclosed [2002 Proxy State- ment, p. 24].

Earnings Analysis

cannot be met in a period, there may be an incentive to take large write- offs in that period to increase chances of making earnings targets in future periods—referred to as taking a “big bath.”

The pressure to report constant or constantly increasing earnings may also result in earnings management, manipulation, or, in extreme cases, even fraud. For example, Leslie Fay reported relatively constant earnings in 1990 and 1991, even though its business was subject to the whims of fash- ion fads and trends. The perceived pressure by some employees to show constant increasing earnings were significant to encourage not only earn- ings management (through items such as prepaid expenses and accrued

expenses) but also through fraudulent accounting entries. 2 The manipula- tion of financial results has been a recurring problem and in recent years has shaken investor confidence in accounting data as the scandals involving Enron, Worldcom, and others have unfolded. Therefore, the financial ana- lyst must not only look for unusual patterns in earnings, but also earnings that are perhaps too predictable. 3

Meeting analysts’ forecasts presents still another pressure for the management of earnings. We know from the wealth of empirical evi- dence that stock prices react to earnings surprises, where surprises are

defined as a difference between expected and actual earnings. 4 In gen- eral, the price of a company’s stock will jump upward at the announce- ment of better-than-expected earnings and the price of a company’s stock will fall quickly at the announcement of worse-than-expected earnings. The typical reaction to a positive earnings surprise is shown in Exhibit 23.1 for the case of Qualcomm, which reported third quarter 1998 earnings per share of $0.33, compared to the forecasted $0.26 per share. As you can see in this graph, both the volume of shares traded and the share prices jumped upward in response to the earnings sur-

2 Martin L. Gosman, Janice L. Ammons, Mary G. Murphy, and Stephanie A. Watts, “Fraudulent Reporting at Leslie Fay: Lessons for Lenders,” Commercial Lending Re-

view (Fall 1996), p. 23. 3 The pressure to meet targets is so well known that customers and suppliers of com-

panies under pressure can take advantage of the pressure to extract discounts or oth- erwise favorable terms (Greg Ip, “Growth Companies Feel Pressure to Book Sales,” Wall Street Journal (September 16, 1997), pp. C1, C13.)

4 Richard J. Rendleman, Charles P. Jones, and Henry A. Latané document that ab- normal returns (i.e., returns in excess of that expected in absence of an earnings an-

nouncement) persist beyond the initial “surprise” (“Empirical Anomalies Based on Unexpected Earnings and the Importance of Risk Adjustment,” Journal of Financial Economics [1982], pp. 269–287). The existence of these post-announcement abnor- mal returns may be the result of a market inefficiency or an empirical measurement problem, as argued by Ray Ball (“The Earnings-Price Anomaly,” Journal of Ac- counting and Economics [1992], pp. 319–345).

FINANCIAL STATEMENT ANALYSIS

prise. Negative earnings surprises are similar in nature, with increased volume yet lower share prices associated with the earnings announce- ment. However, there is usually a lot else going on in the market, so earnings surprises may not always be accompanied by large price adjust- ments. For example, many 1998 quarterly earnings announcements were tempered with gloomy forecasts about the effects of the Asian cri- sis on future earnings, dampening any price reaction to a positive earn- ings surprise for many companies.

Because there is a market reaction to surprises—negative for earn- ings less than expected and positive for earnings better than expected— companies have an incentive to manage earnings to meet or exceed fore- casted earnings. Frustrating the efforts to beat analysts’ forecasts is the

tendency of analysts to be overly optimistic about earnings. 5 In fact, the overestimation of earnings is more pronounced in cases in which com- panies report negative earnings.

EXHIBIT 23.1 Volume and High-Low-Closing Stock Prices for Qualcomm for

Trading Days Surrounding the July 22, 1998 Positive Earnings Surprise

Source: Microsoft Investor, investor.msn.com 5 This over-optimism is documented in the study by Richard J. Dowen entitled “An-

alyst Reaction to Negative Earnings for Large Well-Known Firms,” Journal of Port- folio Management (Fall 1996).

Earnings Analysis

EXHIBIT 23.2 General Electric’s Earnings and Market Value of Equity, 1987–2001

Source: General Electric’s 10-K statements and annual reports, various years. Even with the potential for managed earnings, is there a relation

between earnings and stock value? Consider General Electric’s earnings and prices over the period 1987–2001, as illustrated in Exhibit 23.2. As you can see, the market value of GE’s common stock moves along in tandem with GE’s net earnings, yet the relation between market value and earnings before discontinued items is not as strong. In the case of the period 1999–2001, market value does not move in tandem with either earnings.

Though the example using General Electric illustrates the relation for one company over a specific range of years, the issue is whether earnings and market value are related for most companies. The research into the relation between earnings and value concludes the following:

■ Stock prices change in response to an announcement of unexpected earnings, and ■ Accounting earnings are correlated with stock returns, especially returns measured over a long horizon following the release of earnings. 6

The strong relation between earnings and stock prices may be due to reported earnings being strongly correlated with true earnings (that is,

6 See, for example, the following study: Peter D. Easton, Trevor S. Harris, and James A. Ohlson, “Aggregate Accounting Earnings Can Explain Most of Security Re-

turns,” Journal of Accounting and Economics (1992), pp. 119–142.

FINANCIAL STATEMENT ANALYSIS

earnings in absence of management). Or the earnings-stock price relation may be due to stocks’ valuation being dependent on reported earnings.