Unjustified prerecorded expenses are uncovered by analyz- ing expense levels from year to year. A well-managed company should report fairly consistent levels of expenses each year, with expected increases as sales volume grows; but the relative expense levels should be far below the growth of sales and direct costs.
When you see distortions in these relationships, it should raise questions about the timing of expense recognition.
Current expenses can be exaggerated by setting up an un- usually high reserve or special charge; by writing off acquisition or research costs too quickly; or by speeding up the rate of ex- pense payments to move more expense into the current year.
From 1996 through 1998, Sunbeam had created a $35 million reserve, effectively creating current expenses artificially. In 1997 earnings were increased when the reserve was released. So the re- serve creation and release were used to equalize profits and create the illusion of steady growth. Both Cisco and Toys “R” Us wrote off expenses and created reserves, duplicating a similar strategy of creating current expenses for use later when revenues began to lag. Similar questionable accounting practices were attributed during the late 1990s to Compaq Computers; U.S. Robotics;
and the Walt Disney Company.
with a reliable summary of the core business and, thus, the likely growth potential of a company over the long term. Because the nonrecurring ad- justments so often cloud the growth picture, this S&P standard is now seen as having great value in fundamental analysis.
According to S&P’s definition of core earnings, you begin with the reported operated results of a corporation, and add to it the following ad- ditional items:
• Losses from the sale of assets (capital assets or operating units)
• Merger and acquisition-related charges and costs
• Litigation proceeds received
• Unrealized losses from hedging activities (investment assets)
• Goodwill impairment charges (accounting adjustments for intan- gible assets)
Furthermore, the following items have to be deducted from reported earnings:
• Gains from the sale of assets (capital assets or operating units)
• Unrealized gains from hedging activities
• Litigation costs and settlements paid
• Pension gains (net of interest expenses)
• Employee stock options granted
The process of identifying noncore items can be complex and time- consuming, often involving the interpretation of complex financial state- ment footnotes. For this reason most people can get a fair estimate of the adjustments by concentrating on the major areas such as pension gains, capital gains or losses, profit from the sale of operating units, and em- ployee stock options.
Core earnings adjustments can be quite significant in that they dis- tort results from one year to the next, making all fundamental analysis unreliable. It is imperative that all ratios you use and all trends you de- velop should be based on operating profits, also meaning core earnings.
So you need to examine the annual reports of a corporation; find the noncore items included and remove them; and find the noncore items excluded and add them back in. By focusing only on the major adjust- ments, you simplify the task.
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If you do not want to make your own core earnings analysis of an annual report, you should ensure that your financial advisor or consul- tant knows how to make those adjustments and is able to provide you with a simplified summary of the core operations. In addition to making the report of a specific company more reliable, this also makes company- to-company comparisons valid.
Generally speaking, you will find that corporations that are well man- aged will tend to have a lower volume of core earnings adjustments each year. So many noncore transactions result from periodic accounting changes, restructuring, and attempts to manipulate profits from acquisi- tions and questionable timing. You will also discover that these well-man- aged corporations also tend to exhibit lower technical volatility, meaning less broad movement up and down in the stock’s price. There is a tendency for well-managed corporations to exhibit both fundamental and techni- cally based low volatility. The two aspects of analysis are directly related, and the level of core earnings adjustments is one test of this phenomenon.
A troubling and related attribute of fundamental analysis involves valuation of the corporation itself. Because expense and revenue levels may be distorted significantly, it follows that some balance sheet ac- counts—notably liabilities—may be equally distorted. In Chapter 3, you were advised that if General Motors were to record its liability for pen- sion payments, the company would be worthless.
This is troubling for any stockholder. The realiza- tion that a corporation has no tangible value brings into question the very basis on which stocks are se- lected and held. Many other corporations would be in the same situation if their balance sheets were entirely accurate. The core net worth would be an adjusted valuation of corporate net worth based on making realistic adjustments to all asset and liabil- ity accounts, a suggestion that many corporations, including some long-standing Blue Chips, do not want to consider.
Identifying core earnings is such a sensible idea, it is surprising that it has not come up before. Then again, the problem with the way financial reporting takes place is its widespread inaccuracy.
Key Point
core net worth
the net worth of a corporation re- flecting the accu- rate and total value of all assets and liabilities, including unrecorded or inaccurately recorded items.
The many problems of unreliable reporting, inaccurate accounting, and overly flexible GAAP rules make fundamental analysis far more complex than many people believe. The accounting industry has not taken a lead role in reforming its inadequate system, so every investor needs to consider alternatives to dependence on audited financial state- ments. The next chapter offers one solution: using confirmation, an idea introduced within the Dow Theory, to test trends and to determine if companies are providing you with accurate information.
C o r e E a r n i n g s a s a n A n a l y t i c a l To o l 119
The prospect that many large corporations may, in fact, be worthless due to unrecorded liabilities is very troubling. But that does not mean the problem should be ignored. The real fix is to reform ac- counting standards so that everything—even the bad news—is made completely transparent.
Key Point
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