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Chapter 1. Core Earnings Calculations: A... > A Premise for Stock Selection: Accur...

A Premise for Stock Selection: Accuracy in the Financials

If you are to evaluate stocks based on fundamental analysis of the company, core earnings adjustments are critical to this process. You need to determine that your study is both accurate and complete and that any significant adjustments are made. Because the whole premise underlying fundamental analysis is an evaluation of capital strength and growth potential, core earnings have to be made as a first step.

In this and remaining chapters of the book, we isolate our examples to the major core earnings adjustments. These include stock option expense, pro forma gains from investing pension assets, revenues from discontinued operations, and gains from the sale of capital assets. The purpose in limiting our analysis is to show the material changes without the need for a highly detailed breakdown.

As we demonstrate throughout this book, finding the information you need to make core earnings adjustments is not difficult. By going online to the Web site of each company you wish to study, you can find all of the information you need under “investor relations” or a link with a similar name, and from there you can bring up the latest annual report. You can find the major core earnings adjustments on the income statement, statement of cash flows, and in the footnotes (where details are listed for pension income and expenses and for stock options). While making these adjustments takes some time and effort, it is not difficult to locate the information you need. By isolating your investigation to the major core earnings adjustments, you limit the need for a lot of details; and since you are likely to investigate only a handful of corporations at any one time, the effort is not a large burden.

Market Resource: As an alternative to doing your own research, you may want to subscribe to Standard & Poor's Stock Reports. This is worthwhile if you will need to make core earnings adjustments for more than just a handful of companies throughout the year. Annual subscription cost is $995. For more information, check the S&P Web site at http://www2.standardandpoors.com or contact the client support department at 1-800-523-4534 or 1-800-221-5277. The department can also be contacted by e-mail at clientsupport@standardandpoors.com.

Under the S&P definition of core earnings, the following adjustments are required:

Employee stock options. The dollar value of current-year stock options granted to employees is recognized as an expense under the core earnings adjustment. This may be a major charge to earnings in many instances where annual stock option value is a significant portion of the overall earnings for the same period.

Impairment of goodwill charges. This is the difference between the computed fair value of goodwill and its book value. Traditionally, impairment would be amortized as an expense over a period of years. However, in 2001, the FASB issued a ruling doing away with amortization of goodwill and creating a new annual test for impairment.[5]

Goodwill, as an intangible asset, normally is established when ownership changes and is the value of brand names, product recognition, or reputation. Under the S&P definition of core earnings, no write-off is allowed for the computed difference between the value listed on the balance sheet and the impaired value.

Capital gains or losses. While these gains affect cash flow and corporate tax liabilities, under the definition of core earnings, capital gains or losses are removed from the net income calculation. This is appropriate, since they are nonrecurring as well as nonoperational.

Pension gains. One area that has been especially troubling for financial analysts is quantifying reported gains from pension asset investments. Companies base their income on expected rates of return—pro forma profits—which often have no basis in reality. The actual returns on plan assets are not used exclusively to report such income. Thus, there is a large gap between reality and what is reported. As a consequence, large numbers of corporate pension funds are underfunded. Aggregate pension plans for the S&P 500 companies were underfunded by as much as $243 billion at the end of 2002.[6]

Underfunded amounts are staggering for many companies. Estimates of underfunded dollars amounts include General Motors, $29.4 billion; Ford Motor Company, $14.3 billion; and Boeing, $6.8 billion. These large gaps in funding are at least partially due to poor market performance; however, the potential consequences on valuation cannot be ignored. About 30 companies are estimated to be underfunded by 25% or more of current equity market capitalization. In other words, pension plans in those situations have claims on over one-fourth of the shareholders' interest in stock value.[7]

With these potentially significant impacts in mind, reported pension gains are excluded from core earnings. To make financial statements even more accurate, corporations may eventually be required to adjust their reported equity by removing pension assets and liabilities from the balance sheet. In cases of underfunded plans, the effect would be a reduction in capitalization value, which would provide investors with a realistic view of the company's true valuation. We may refer to this adjusted value as core net worth.

Under the S&P calculation, service cost expense is allowed, but expected return on plan assets is excluded in the core earnings calculation. Interest cost is allowed, but only to the extent that it exceeds actual return on plan assets.

Reversal of prior year charges. Under GAAP, companies may adjust current earnings for reversals of prior year restructuring charges. Those credits are not recognized by S&P in the core earnings calculations. S&P recommends that as an alternative, those reversals are more properly used to restate earnings from prior periods, where those charges properly apply.

The effect of this decision is to limit current-period earnings to current-period activity. When companies reverse prior years' charges, it distorts today's core earnings, often making it difficult, if not impossible, for analysts to develop reliable trend analysis studies.

Merger and acquisition fees. Under the S&P model, no adjustment is needed for fees associated with mergers and acquisitions, assuming that these activities are related to a company's primary business. While the question is not addressed specifically in the core earnings calculation, it would follow that if companies begin acquiring smaller companies whose business activity is not related to that primary activity, then associated fees should be excluded from core earnings. For example, between 1993 and 1995, Waste Management acquired 444 companies, most unrelated to core earnings.[8] Enron formed more than 800 off-shore subsidiaries and affiliates, a similar technique also aimed at distorting earnings. By excluding noncore merger and acquisition activities, the picture becomes far clearer.[9]

Litigation and insurance settlements. These are excluded because they are not part of core earnings. However, payments to settle lawsuits and related matters can be substantial. Companies are allowed to write off their litigation losses; these distort the year-to-year analysis of earnings and do not properly belong in the study of a company's principal business.

We propose that your investigation can be limited to adjustments for stock option expense, pension pro forma income, income or loss from discontinued operations, restructuring charges, and capital gains or losses from the sale of assets—as well as any other significant extraordinary and nonrecurring items. The handful of suggested adjustments usually constitute the major core earnings adjustments and are easily found on the financial statements and in the footnotes of listed companies. If you are already performing fundamental tests on corporate financial statements, the information is already available to you. The relatively small adjustments for goodwill impairment or relatively minor adjustments can be ignored, remembering that the purpose of these changes is to estimate the likely recurring levels, thus trends, in sales and earnings.

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