What Earnings Figure To Use: Pros And Cons Of Each


What Earnings Figures Should I Use? by David Merkel, CFA of Aleph Blog

One of the challenges in investing is understanding whether stocks are really earning above expectations or not.  Many companies, especially the large ones have their adjusted or modified GAAP earnings.  I can sympathize with the companies if the adjustments make the adjusted earnings more like free cash flow.  But if not, I disagree.

GAAP accounting is very good, better than IFRS, but not perfect. There are two uses for earnings figures, and they are different, because they serve different time periods.

When analyzing quarterly earnings, heed the adjusted earnings figure, but review that calculation to see that is is on the same basis as it was over the last year.  Shenanigans are often played here.

Second, look over a 3-, 5-, and 10-year periods: see how much actual earnings lagged behind management estimates.    Yes, there are temporary fluctuations in earnings.  But when they repeat again and again, it indicates that management is sloppy.  This is structural and not sporadic.

Don’t invest in companies that regularly have significant one-time disappointments.  What is regular should be treated as regular.  Companies that regularly have to adjust earnings higher then GAAP deserve lower valuations.

Here’s another way of thinking about it: writedowns usually reflect the past, indicating that past profitability wasn’t so high.  If writedowns come frequently, it means that management has made bad/liberal accounting decisions.  This could be a stock to avoid.

Thus in the short run, look at adjusted earnings, but critically.  In the long run, look at unadjusted earnings, because managements should be responsible for their long-term errors.



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.