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.
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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