Friday, August 27, 2010

Beware Earnings as F.O.E.

Earnings reports and earnings season every quarter are times when the market responds to impressions rather than researched information.  Too a large extent the public cannot be entirely blamed, because they are relying on news reports and financial information from the companies.  In as much as these do not reflect the underlying tax accounting manipulations, real cash flow, the types of cash, and other legal legerdemain that constitute forward operating earnings (FOE), the information being publicly passed and digested does not give a reliable value of the security or the market as a whole.

John Hussman has written about the problem of forward operating earnings on many occasions in his weekly commentaries.  On July 19, he discussed how dividends are not properly taxed and this leads to companies to report earnings and then waste the "...retained earnings on speculative acquisitions and incentive compensation to insiders...".  He then went on to discuss how he warns investors to be skeptical of valuation metrics built on forward operating earnings as they are estimates of next year earnings but omit a whole range of charges such as bad investments, loan losses, restructuring charges, etc.  This generates statistically distorted and overly optimistic projections as substantiated by historical data.  He then illustrates how Tobin's q ratio, which is based on comparing market value to replacement cost, as advocated by Andrew Smithers and Schiller's CAPE, which is based on the ten year average of actual net (not operating) earnings provide consistently comparable valuations.  "Ultimately, the value of any security is the properly discounted stream of cash flows that the security will deliver into the hands of the investor over time."  Net earnings not operating earnings are the important and more accurate information.  " earnings represent the only amounts that investors can hope to obtain, and then only if the net earnings are distributed as dividends or invested in productive activities that don't get written off later."

On August 2, 2010, Hussman continued his concern with the increasingly careless use of operating earnings as a misleading measure of stock valuation.  "The two main failures of standard FOE analysis are that 1) analysts assume a long-term norm for the P/E ratio that properly applies to trailing net, not forward operating earnings, and; 2) analysts fail to model the variation in prospective earnings growth induced by changes in the level of profit margins, and therefore wildly over- or underestimate long-term cash flows that are relevant to proper valuation. By dealing directly with those two issues, we can obtain useful implications about market valuation."  Analysts tend to treat these hypothetical operating earnings to create forecasts "... as if they are distributable cash flows. Unfortunately, operating earnings exclude a whole range of charges that may not occur on an annual basis, but are legitimate costs and losses incurred as part of the ordinary course of business. Meanwhile, operating earnings often include a benefit from those very same "extraordinary" sources - provided they make positive contributions (witness the large boost to the operating earnings of major banks this quarter, resulting from the reduction in reserves for future loan losses)."

On August 9th, Hussman repeated the importance to the investor of being able to properly assess stock valuations.  He then continues with warning investors to not believe that cash on the balance sheet could "... suddenly be used, in aggregate, for new investments and capital spending." Often, this cash is in the form of loans to the government or private companies in the form of T bills and commercial paper.  Consequently, these investment savings are not available to spend.  These marketable securities are someone's liabilities.  Often, cash is the result of the issuance of corporate debt.  You cannot look at cash assets and ignore liabilities in national and global balance sheet of all assets and liabilities; what affects one side of the balance sheet effects the other side of the economic balance sheet of all corporations, individuals, and government.

When you look at market valuation and the value of a security, you need to dig into the actual detailed financial information and historical data and use that data in a rigorous model that yields information and not forecasts.  Too many market pundits will cry earnings and pronounce them as positive or negative based on summaries and estimates of forward operating earnings when they should be focused on net earnings, in what form cash is held, liabilities, and the use of earnings.  Too often market talk about earnings is the shot used to stampede the herd.  Often, market commentators have vested positions in how the market moves or, worse, political motives in forming public opinion.

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