Those record profits that companies are reporting may not be all they’re cracked up to be.
As the stock market climbs ever higher, professional investors are warning that companies are presenting misleading versions of their results that ignore a wide variety of normal costs of running a business to make it seem like they’re doing better than they really are.
What’s worse, the financial analysts who are supposed to fight corporate spin are often playing along. Instead of challenging the companies, they’re largely passing along the rosy numbers in reports recommending stocks to investors.
“Companies are tilting the results,” says fund manager Tom Brown of Second Curve Capital, “and the analysts are buying it.”
An analysis of results from 500 major companies by The Associated Press, based on data provided by S&P Capital IQ, a research firm, found that the gap between the “adjusted” profits that analysts cite and bottom-line earnings figures that companies are legally obliged to report, or net income, has widened dramatically over the past five years.
At one of every five companies, these “adjusted” profits were higher than net income by 50 percent or more. Many more companies are in that category now than there were five years ago. And some companies that seem profitable on an adjusted basis are actually losing money.
It wasn’t supposed to be this way. After the dot-com crash of 2000, companies and analysts vowed to clean up their act and avoid highlighting alternative versions of earnings in a way that could mislead investors.
But Lynn Turner, chief accountant at the Securities and Exchange Commission at the time, says companies are still touting “made-up, phony numbers” as much as they did 15 years ago, perhaps more, and few experts are calling them out on it.
“The analysts aren’t doing enough to get behind the numbers that management gives them to find out what’s really going on,” Turner says.
Offering an alternative view of profits that leaves out various costs is not new. It’s perfectly legal, and sometimes helpful as a tool for investors to gain insight into how a business is doing.
But with stocks breaking record after record and the current bull market entering its seventh year, there’s more money riding on the assumption that the earnings figures being touted by companies and analysts are based on sound calculations.
“The longer the rally, the bigger the downside because of all the smoke and mirrors,” says money manager John Del Vecchio, co-author of “What’s Behind the Numbers?” a book on how profit reports can mislead.
In its study, AP compared bottom-line profit figures that follow rules called generally accepted accounting principles, or GAAP, to the adjusted profit figures calculated by financial analysts and collected by S&P Capital IQ. AP looked at companies in the Standard & Poor’s 500 index.
Most of the time, the adjustments made companies look better by leaving out things like costs related to laying off workers, a decline in the value of patents or other “intangible” assets, the value of company stock distributed to employees, or losses from a failed venture. Critics argue that these are regular costs and shouldn’t be excluded.
Meanwhile, Stocks are getting more expensive, meaning there could be a greater risk of stocks falling if the earnings figures being used to justify buying them are questionable. One measure of how richly priced stocks are suggests trouble. Three years ago, investors paid $13.50 for every dollar of adjusted profits for companies in the S&P 500 index, according to S&P Capital IQ. Now, they’re paying nearly $18.