When evaluating a public company in the olden days that is, anytime up until two or three years ago only one number truly mattered: net income. It was the literal bottom line and no matter what the circumstances (special charges, one-time events, non-cash transactions), it gave investors their most important piece of information: How well is this company doing?
Such thinking became hopelessly outdated in the go-go ’90s. No longer was net income such a big deal. Instead, we had pro-forma earnings, operating earnings, cash flow and the current favorite, EBITDA (earnings before interest, taxes, depreciation and amortization).
At certain times in certain circumstances, all these measurements have value. Pro-forma earnings can be useful when evaluating a company that has merged or is in the process of going public. Cash flow, defined as cash receipts minus cash disbursements, is helpful in monitoring how much money is available to pay dividends or service debt.
But nothing can replace net income although many companies have tried. They have, in fact, muddied the waters by highlighting numbers that often exclude the bad news. This props up their earnings per share figures so important to Wall Street.
It also creates confusion in determining one of a company’s most important yardsticks its P/E ratio. A Wall Street Journal analysis published last week found that for every dollar of operating earnings S & P; 500 companies reported in their most recent three-month periods, 60 cents would not have been there if those companies hadn’t excluded various costs.
Unfortunately, Wall Street penalizes companies that play by the rules. In the mania for ever-higher prices, all that’s counted in recent years is a high EPS and then, bettering that number in the next comparable reporting period. A penny below or above expectations can dictate how the stock performs, which leads companies to engage in elaborate number finessing. The latest example: Waste Management beat earnings expectations for the second quarter, but only by excluding what it called “unusual expenses” that covered $1 million to paint its garbage trucks. If that’s unusual, what’s normal?
There’s a growing acknowledgement that such sleight-of-hand accounting is out of control. But no one has taken responsibility for the problem not the exchanges, not the Securities and Exchange Commission and certainly not the companies.
Last week, the Financial Accounting Standards Board, the rule-making body for the accounting industry, meekly responded to the Journal’s findings by saying it would consider ways to better standardize company financial statements. But the FASB has no enforcement power when it comes to telling a company how to report earnings, which is at the heart of the problem.
True reform must start with the SEC, which can set tighter regulatory standards on financial results starting with specific parameters on what constitutes an extraordinary charge and how it should be calculated in determining earnings. This is a formidable undertaking that requires industry-wide cooperation. Which means don’t hold your breath. But without such government intervention, individual investors faced with deciding where to put their life savings will find the navigating difficult, if not impossible.
