Do investors get a straight story about company earnings?
It’s well known that the traditional way of measuring profits, by generally accepted accounting principles (GAAP), has been gradually, increasingly overshadowed by other metrics in company press releases, analyst forecasts, and clearinghouses that provide data on both predicted and actual earnings.
Even though these alternatives, known collectively as “Street earnings,” incorporate non-GAAP measures, they have been touted as providing a better picture of financials for many companies. Today about 90% of S&P 500 companies use at least one non-GAAP measure in earnings releases.
But this favorable view of Street earnings has hardly gone uncontested. Among scholars and investors alike, there have been outspoken doubters, among them Charles Munger. The Berkshire Hathaway vice chairman once referred to a widely used non-GAAP measure, EBITDA (earnings before interest, taxes, depreciation, and amortization), as “[B.S.] earnings.”
Now, new research seems bound to add appreciably to such doubts. A study to be presented on Aug. 7 at the annual meeting of the American Accounting Association implicates the use of Street earnings in a striking recent development.
The research reveals a proliferation of large earnings surprises whereby quarterly per-share earnings exceed analysts’ forecasts not by just a penny or two, but by much more. Greatly abetting this development has been the manipulation of non-GAAP numbers — for example, by asymmetrically including transitory items that increase firms’ earnings and excluding transitory items that lower them.
So striking has this trend been that the study’s authors, Paul Griffin of the University of California at Davis and David Lont of the University of Otago in Dunedin, New Zealand, believe it calls recent market results into question.
“There are those,” they write, “who might claim that so far this century the U.S. economy has experienced such an unusual period of economic growth that it has taken … analysts and investors increasingly by surprise each quarter with better-than-expected earnings performance for almost two decades. This view strains credulity.”
Analyzing surprises in Street quarterly earnings among the S&P 500, the professors found a doubling over a 17-year period in the proportion of reported earnings that were between 5 and 15 cents per share above analyst forecasts.
The results in that earnings range increased from about 12.1% of all earnings surprises in 2000 to about 25.5% in 2016.
At the same time, there was a precipitous decline in the proportion of Street earnings reports that barely met analysts’ predictions. Thus, between the two periods 2000-2008 and 2009-2016, the average proportion of positive earnings surprises that were squeezed between zero and a penny dropped by about 15%, and the proportion between a penny and two cents fell by about 5%.
In marked contrast, the pattern of quarterly earnings surprises as measured by GAAP was much more stable over the same 17 years. For example, among the S&P 500, GAAP earnings results that were 5 to 15 cents per share above expectations represented about 10% of earnings surprises in the two years 2000-2001 and about the same percentage in 2015-2016.
In essence, the growing use of Street measures employing non-GAAP numbers has made earnings manipulation a new ballgame.
“It used to be,” Griffin and Lont write, “that a significant number of firms reported earnings that either met or just exceeded Street expectations, suggesting that, to accomplish this result, managers would either make small late changes to pre-managed earnings or that analysts would intentionally under-forecast reported earnings by similar amounts…. This behavior has mostly died out.”
Now, management’s earnings manipulation “must be of a different form and, possibly, one more acceptable to shareholders’ agents such as auditors, directors, and regulators,” the study report says. “Non-GAAP earnings management is one such form. If these monitors [are] focused on small changes around zero earnings surprise … we would expect to observe fewer small positive earnings surprises … and more large earnings surprises.”
In other words, if the monitors are intent on guarding against penny-ante manipulation, as they traditionally have been, it makes sense for managers to up the ante. Doing so not only brings handsome rewards but is much facilitated today by a growing acceptance of non-GAAP numbers.
Stock analysts are also likely contributors to this trend, the authors suspect. As they explain, analysts may “increasingly bias their Street expectations downwards to generate a more positive response [from earnings surprises] for their clients – that is, they engage in strategic pessimism.
“This reason has merit if the reporting firms reward analysts with more business or more access to the firm information as a result of helping firms create a positive earnings surprise.” Although the researchers found that analyst forecast accuracy has not significantly declined over the 17-year study period, they note that an improvement in accuracy achieved in prior years has come to a halt.
Complicit, too, Griffin and Lont believe, are clearinghouses that compile analysts’ forecasts and company earnings. “What if the extant market reactions to positive Street earnings surprises were to induce … analysts to produce even higher Street earnings surprises in search of generating an even stronger stock market response?”
The study’s findings are based on analysis of hundreds of thousands of quarterly earnings forecasts and reports involving more than 4,700 companies. While the trend toward heightened earnings surprises is seen across the entire sample, it is most pronounced among the S&P 500.”
As to how regulators should respond to the trends uncovered by the study, Griffin notes that, although the SEC has expressed concern about the growth of non-GAAP metrics, it has brought only one action over companies’ improper use of them.
“The issue has been very much on the back burner,” he adds. “Given our findings, maybe it’s time to move it from there.”