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Part 1: The Techniques > Core Earnings Calculations: A Revised Approach

Chapter 1. Core Earnings Calculations: A Revised Approach

Imagine going to your bank to apply for a loan and filling out an application on which you include a full year's estimated income as an account receivable. At the same time, you leave out several important liabilities. Even more unthinkable, imagine showing interest, dividend, and capital gains income based on what you think you are going to earn through investments over the next few years.

No self-respecting banker or underwriter would allow you, as an individual, to inflate your income and net worth with such moves. However, corporations inflate their numbers all the time. They include accounts receivable, offset by current income, often based not on the timing of delivery but on orders placed; they leave employee stock option expenses off their income statements; and they report estimated investment income for pension assets (the infamous pro forma income number that has caused such controversy).

Why do corporations get away with such liberal accounting interpretations when the same rules would be preposterous for individuals? One reason is that the rules (more precisely, the guidelines) under the GAAP system allow aggressive interpretations of the numbers on the part of our publicly listed corporations. Many of the traditional rules are under review, and the long, slow process of reform has begun. But it will take years. The GAAP system—as a decentralized collection of opinions, research papers, and general guidelines—does not reside in any one place. Rather, it is the combined body of knowledge of the accounting industry, led by the AICPA and FASB, but lacking any real authority to enact change.

The process of cleaning up the problems of GAAP will be slow. The consequences of the flaws in GAAP are glaring. These flaws have enabled many companies to overstate sales and net earnings and even to deceive stockholders through questionable and aggressive accounting decisions—with the blessing of the “independent” auditing process—to bolster stock prices and maximize incentive compensation to the CEO and CFO. Conflict of interest among executives and auditing firms led to most of the problems of Enron, WorldCom, and dozens of other publicly listed companies, and even to the sudden and rapid demise of Arthur Andersen.

The solution to the problems of how financial results are reported cannot be simple or quick. We need to depend on the SEC and state securities agencies to enforce the laws on the books, on the exchanges to police listing standards, and on corporate executives themselves to restore ethical practices to the boardroom and in dealings with auditing firms as well as with the public. In other words, fixing this problem is going to involve changes on many levels. Meanwhile, what are analysts, financial planners, and investors supposed to do to (a) protect their interests, (b) ensure reliability in the analyses they perform, and (c) offer advice and recommendations on an informed basis? If the very numbers are inaccurate, how can any form of fundamental analysis have validity?

Key Point: The inaccuracies found in financial reporting require long-term reform. In the meantime, investors and analysts need reliable ways to value companies whose stock they buy and hold. This is where core earnings adjustments become so important.


The solution is found in core earnings adjustments. By definition, core earnings are those earnings derived from the primary, or core, activity of a company. Looking at it from another angle, we can also conclude that core earnings are those earnings that can be expected to contribute to long-term growth. This distinction is at the heart of our discussion. Clearly, we cannot include income from discontinued operations, capital gains, or pro forma investment return in a long-term forecast of an earnings trend. At the same time, we cannot exclude substantial expenses like employee stock options if we are expected to identify the likely permanent long-term growth trend.

Standard & Poor's has begun using a calculation of core earnings to modify its corporate bond rating system. This is a significant change from previous methodology and, for some of our largest corporations, a chilling one. Many companies have included in their reported earnings a number of noncore items that, if excluded from the S&P bond rating analysis, may reduce ratings from investment grade down to questionable or even high-risk levels. This could affect long-term capitalization as well as immediate working capital; so the decision to make such adjustments is a serious one, and it demonstrates how serious the problem has become. The aggressive accounting policies employed by many companies have greatly inflated growth projections and, as a direct consequence, stock prices as well. Actual reform to GAAP may take many years, but analysts and financial planners need to be able to apply those adjustments to today's numbers in order to compare corporate value in real terms.

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