Capital Markets

How Good Are Those Earnings, Really?

Pro forma results are apparently alive and well; earnings surprises are less surprising than they may appear.
Stephen TaubNovember 9, 2004

Third-quarter corporate operating earnings are 22 percent greater than earnings stated according to generally accepted accounting principles, according to USA Today, citing data from Standard & Poor’s. That’s twice the 11 percent difference between operating earnings and GAAP earnings during the second quarter, which in turn was more than twice the 5 percent difference during the first quarter.

“Anytime you see the spread getting wider, it should raise a red flag,” said Reuters Research analyst Ashwani Kaul, reported the paper.

Although the gap is the widest it’s been in two years, USA Today also pointed out that since 1988, operating earnings have averaged 21 percent greater than GAAP earnings. In addition, the Securities and Exchange Commission’s Regulation G, enacted in 2003, makes it more difficult for companies to hide ”special charges” that enable them to report higher operating earnings. (As CFO reported earlier this year, however, “there’s little evidence that Reg G has had much effect on pro forma reporting.” See “A Matter of Emphasis.”)

Another measure that may deserve a second look concerns “earnings surprises.”
The Wall Street Journal, citing data from Thomson First Call, reported that 64 percent of the S&P 500 beat their earnings estimates for the third quarter, but Goldman Sachs chief sector strategist David Kostin is not so impressed.

Kostin, in line with common wisdom, believes that companies frequently guide analysts to an earnings number that they feel they could beat — say, by a penny per share — according to the Journal. He prefers to define “earnings surprise” as a result that varies by more than one standard deviation from the analysts’ estimate.

After examining 422 of the S&P 500, reported the Journal, Kostin found that only 36 percent — not 64 percent — had what he defines as a positive surprise in the third quarter. In the second quarter, of the 420 companies that had reported earnings by the same time, 46 percent had a positive surprise.

In other words, wrote the paper, by Kostin’s lights the third quarter enjoyed fewer positive earnings surprises than the second. Not surprisingly, the number of companies reporting negative earnings that departed by more than a standard deviation from the average estimate rose to 11 percent in the third quarter from 9 percent in the second, according to the report.