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Chapter 1. Core Earnings Calculations: A... > Applying the Core Earnings Idea

Applying the Core Earnings Idea

When you begin to critically review a company as a potential investment, one of the first things you check is the results of operations—revenues and earnings. Of course, you assume that the numbers themselves are accurate. But what if those numbers are inflated because they include nonoperational or one-time items? What if those numbers exclude significant expenses that, if disclosed, would drastically change your view about that company?

The very way that companies report earnings is flawed. Published income statements should provide you with a dependable roadmap to estimate likely growth and should be limited to only those items that are derived from operations. Under the current rules of GAAP, many nonoperational items are treated improperly; the rules allow these distortions, and you are expected to perform your detailed analysis based on what you are provided in an audited statement.

What does this problem mean to you? Many of the nonoperational items included as income or excluded from operational costs and expenses are material enough that the true profit picture often is far different than what you see. Later in this chapter, we provide some examples. This distortion of the true picture has led to the beginnings of a new but logical idea: companies would better serve their stockholders by reporting their results of operations on the basis of core earnings. Under this ideal, all core earnings items would be included in the report, and all noncore items would be left out. This does not mean that the excluded or noncore items are not valid forms of income or expense, but only that they should not be included in an analysis of long-term growth.

A reasonable premise is that any analysis you perform for the purpose of identifying stocks is more accurate if based on realistic numbers. Returning for the moment to the analogy of a personal loan application, your banker would expect you to provide a realistic summary of your income. If you had recently sold a boat and included the proceeds as “annual income,” the loan officer would remove it, knowing that the proceeds are not part of your recurring annual salary. By the same reasoning, adjusting reported results of operations is intended to state corporate results on a realistic basis. Only with this adjustment can you calculate potential growth and compare one company to another. Without making an adjustment to arrive at core earnings, any comparison you make between companies, or from one year to the next for a single company, are likely to be distorted. If two or more companies have had differing noncore experiences during the year, a company-to-company comparison is also flawed. With core earnings adjustments, it becomes possible to make operational comparisons between those companies.

Key Point: There is nothing mysterious about the premise underlying core earnings adjustments. It is the process of restating annual income on a realistic and accurate basis.


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