Inside S&P's New "Core Earnings"
What does a company really earn? Amid accounting scandals and confusing earnings reports, investors are demanding a clearer profit picture from Corporate America. In an effort to impose some consistency on the numbers that companies report, Standard & Poor's has published a set of new definitions it will use for equity analysis to evaluate operating earnings of publicly held companies in the U.S.
"The increased use of so-called pro forma earnings and other measures to report corporate performance has generated controversy and confusion, and has not served investor interests," said S&P President Leo O'Neill in a press release (for more explanation from S&P's Sam Stovall, see Video Views, 5/14/02, "S&P's New Math").
That controversy and confusion is behind S&P's efforts to calculate "core earnings" -- the aftertax earnings generated from a company's principal business or businesses. S&P will include in its calculations expenses for employee stock-option grant, restructuring charges from ongoing operations, write-downs of depreciable or amortizable operating assets, pensions costs, and purchased research and development.
REFLECTED IN THE S&P 500.
What will S&P leave out of the equation? Impairment of goodwill charges, gains or losses from asset sales, pension gains, unrealized gains or losses from hedging activities, merger-and-acquisition-related fees, and litigation settlements will not be part of core earnings.
S&P will include the components of its definition for core earnings in its U.S. database. In addition, the new earnings standard will be calculated and reported for S&P's U.S. equity indexes, including the S&P 500. And S&P's own equity analysts will incorporate the new standard in their research.
S&P, like BusinessWeek Online a division of The McGraw-Hill Companies, began the process in August, 2001, by consulting with securities and accounting analysts, portfolio managers, academic research groups, and others. Its aim was to build a consensus for changes that will "reduce investor frustration and confusion over growing differences in the reporting of corporate earnings."
Here are the facts investors need to know about S&P's new standard for measuring earnings:
What are core earnings?
Under S&P's definition, they measure the earnings power of a company's business. Core earnings represent the difference between the revenue of a company's principal, or core, business and the costs and expenses associated with deriving that revenue.
A simple example would be a chain of retail stores. The core business is running stores. Look at the revenues and the expenses from those stores, and you can find core earnings. While many retail chains may buy and sell real estate, that isn't their main business. Neither is running a pension fund or many other things that such a company may do.
S&P believes that for an equity investor to make an investment decision based upon a company's reasonable earnings expectation, it's necessary to understand how that organization's core business will perform in the future.
Each company and each industry is different, so how can you have a "one-size-fits-all" earnings definition?
You can't. But there can be one common goal for all accounting -- a standard calculation of a company's core-business earnings. That's S&P's goal. Its white paper, Measures of Corporate Earnings, addresses issues that are found across most companies in most industries. Certainly, unusual items occur once in a while. But a company that's committed to using "core earnings" to help investors understand the true nature of its business should be able to explain the unusual items and treat them properly.
The white paper notes that pro forma reports do have a proper place when specific assumptions must be made, providing all those assumptions are fully described and explained.
Why use this new standard to recalculate a company's operating earnings? Aren't current accounting practices sufficient?
In the last few years, the reliability of earnings reports has dramatically decreased. Since S&P's business is based on providing investors with reliable information, analysis, and advice, it believes the time is right for the investment community at large to take corrective action. Therefore, S&P is pushing for earnings reports that must be understandable, consistent, and transparent.
Will S&P ever change its definition for core earnings?
The basic idea won't change. To make its calculations, S&P will focus on a company's main business. However, as business reporting improves and accounting rules change, the definition may be refined.
How will S&P use its core earnings measure?
First, its equity analysts will consider core earnings when they examine and review stocks. While neither core earnings nor any other single measure will determine an analyst's opinion, S&P believes earnings measures that are consistent across companies and over time are important.
Second, to assist its own equity analysts, and analysts and investors in general, S&P will begin calculating core earnings per share for its U.S. indexes and the main sectors in those indexes. Third, supporting data will be in S&P COMPUSTAT database later this year.
Has S&P talked to others about its core earnings standard?
From the outset, S&P's investment-analysis group consulted regularly with numerous securities and accounting analysts, portfolio managers, academic research groups, and others. While disagreements exist on the details, everyone concurs that this is an important, positive effort for investors and the broader financial industry.
Why is the expense treatment of stock options so important?
In 2000, the cost of stock options was nearly 10% of profits, a substantial expense. For 2001, the value will be even higher. If stock-option costs are ignored, profits may be misrepresented. Moreover, stock options can directly affect shareholders because when options are exercised, new shares are issued, and shareholders' existing holdings are diluted.
How does S&P's measure of core earnings take restructuring into account?
In arriving at its core earnings calculation, S&P includes as an expense the restructuring charges that stem from ongoing operations. From time to time, a company may make some changes to its core business. It may drop a product line or close a factory. Restructurings often result in additional expenses, including severance payments to employees who lose their jobs and write-downs of assets that are no longer needed.
However, some restructurings may entail completely abandoning a line of business, and the change is a discontinued operation. In these cases, the charges aren't included since the company is no longer in that business.
Most restructurings, though, are an adjustment to an ongoing part of the core business. When this happens, the costs involved are part the business and are included in core earnings.
What about goodwill impairment charges?
Until this year, companies were required to amortize goodwill, showing a cost representing a scheduled portion of the goodwill each period. Under the new Generally Accepted Accounting Principles (GAAP), companies do not show a charge each period for goodwill. However, if the goodwill becomes impaired -- i.e., it turns out to be worth less than its book value -- a charge must be taken. Given the new GAAP rules, S&P doesn't include goodwill-impairment charges in core earnings.
If S&P's core earnings measure had been available a year or two ago, would investors have fared better in the bear market?
If corporate reporting had been more consistent and transparent than it has been, many corporate reports boasting profits would have shown losses. As a result, investors would have had more detailed information on which to base their decisions.
Will S&P use core earnings as part of its debt-rating activities?
Yes. The accuracy of earnings and trends in earnings have always been a component of credit analysis and thus adds value to that process. Earnings are a major component in cash-flow analysis and are a part of S&P's debt-rating methodology.