Capital Markets

But Can it Core a Annual?

Tool of the future? Core earnings an attempt to gauge business -- not bookkeeping -- gains.
Tim Reason and John GoffMay 14, 2002

Here’s another metric to throw in your hopper.

This morning, ratings agency Standard & Poor’s announced its adoption of a new yardstick for evaluating corporate performance. Called “core earnings,” the measurement represents the difference between the revenue of a company’s principal business and the costs and expenses associated with deriving that revenue.

S&P’s management said it developed the core earnings calculation in response to the recent rash of corporate restatements and financial scandals. “[Accounting] creativity is definitely on the rise,” noted David Blitzer, chief investment strategist at S&P, during a telephone conference. “But reliability is not.”

The core earnings measurement starts with GAAP net income — with a few significant alterations. First off, core earnings treats the cost of administering — and contributing to — an employee stock option program as an expense. That alone could have some serious implications for the earnings numbers of U.S. corporations. “Across the S&P 500,” Blitzer claimed, “options expense would have reduced earnings by 10 percent.”

Core earnings also factors in writeoffs and restructuring costs. According to S&P, these costs are adjustments to ongoing operations — and should be treated as such. “Most of the time, these adjustments are just as real as if [a company] hadn’t shut down an operation,” notes Blitzer.

Interestingly, management at S&P decided to exclude goodwill impairment from its core earnings measurement — a move that will undoubtedly rankle some feathers at FASB. “When goodwill is impaired, there is a loss in value,” explains Blitzer. “So if [a company] takes a charge, it winds up having to pay for it twice.”

S&P management says the company’s analysts will consider core earnings when they analyze and review stocks. In addition, S&P will begin calculating core earnings per share for the company’s U.S. indices — the S&P 500, for example.

Such a rejigging could have a interesting effect on corporate price-to-earnings ratios. According to Blitzer, core earnings for most corporates will be lower than operating earnings — the figure S&P had been using for its P/E calculations. When asked if the higher ratio means the market is still overvalued, he replied: “In the short term, yes. That maybe creates a little nervousness.”

More than a little nervousness. But Blitzer thinks higher P/E figures pale in comparison to the larger issue at stake. “If we leave the current [accounting] situation unchanged and untouched,” he argued, “investor confidence will slowly but surely seep away.”