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Why Does it Make Sense to Use Operating Earnings?

Fri, Sep 5 2008, 06:22 GMT
by Comstock Partners Team

Comstock Partners Inc.

We have been discussing this topic for the past 10 years without getting much support from anyone else on Wall Street (except Barron's magazine).
We've been trying to convince anyone who would listen that using operating earnings (which excludes write-offs) makes no sense whatsoever, and using GAAP (reported earnings) makes much more sense. In fact, this is discussed in one of the special reports titled "What is the Real P/E?" (left side of our home page) and the Barron's article on the home page under "Comstock in the News".

This subject, which at least merits debate, has moved to where virtually the entire investment community is using "operating earnings". In fact, there was a Wall Street Journal article last Thursday which dealt with the second quarter results that are expected to be down 29% according to S&P 500 companies. Howard Silverblatt, a senior analyst at S&P and main spokesman for the firm was quoted throughout the article. Howard and Comstock have been in close touch ever since we started talking about this subject and he has been very helpful whenever we ask him any questions.
Since there was no mention of which earnings the Wall Street Journal was referring to, we emailed Howard and he confirmed that it was "operating earnings" and that virtually all of Wall Street is using "operating earnings" when they refer to earnings of the S&P 500 or the P/E of the S&P 500. Maybe we should just "let it go" and get on board with the rest of Wall Street in focusing on "operating earnings". However, if you know us, you know we will not give up on the point we keep trying to make---everyone should be using "reported earnings" since that is the GAAP (Generally Accepted Accounting Practices) methodology--see S&P website  http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS.  

Last week we also heard from a very sophisticated investor, Leon Cooperman, who was being interviewed on TV about the market's valuation. Mr. Cooperman explained that he was cautiously optimistic mainly because of the S&P 500 valuation. He explained that the S&P 500 is "trading at 14 times earnings if you add back non-recurring charges that are seemingly RECURRING". Why would such a sophisticated investor ever use operating earnings? He clearly understands the drawbacks of using earnings that "exclude write-offs" (that are by implication non-recurring) but recur over and over again.

We find it hard to believe so many analysts claim that the S&P 500 is trading at 14 times earnings. The only thing we can come up with is that they must average the earnings estimates of the S&P analysts of $80 in 2008 and $108 in 2009. Of course, many analysts claim that forward operating earnings (using 2009) is 12 times earnings. We, on the other hand, believe that reported earnings should be used. Trailing 12 months reported earnings of $52 equates to a P/E of about 24 and the earnings estimates of $63 in 2008 and $65 in 2009 equates to a P/E of around 20. Twenty times earnings has been the area of market tops over the past 100 years with the exception of the financial mania in the late 1990s.

We think analysts should use the last 12 months to be consistent and because no one knows for certain what future earnings will be. For example, the forward earnings (2009 estimates) were $98 for 2008 and $112 for 2009 in January of this year-just eight months ago! They have been gradually coming down all year. And just last week the chief investment strategist at Morgan Stanley, Mr. Chakrabortti, lowered his estimate of "operating earnings" to $78 in 2008 and $84 in 2009. His reasons are similar to what we keep warning our readers about-- demand destruction worldwide. The main point here is that no one really knows the forward earnings, so why not be consistent and use the last 12 months earnings.

We may be able to get off this subject if the SEC pulls the plug on U.S. accounting standards and requires all publicly listed American companies to follow an international model instead. This could take place over a few years and eventually cut costs for companies and smooth cross-border investing. Last week the Wall Street Journal reported, "Investors worry it will create CONFUSION"! We just hope the SEC makes U.S. companies use any type of consistent reporting in the future as long as they don't allow exclusion of non-recurring charges (that as everyone knows are RECURRING).
This discussion was not mentioned in the WSJ's article, but nothing could be as confusing as what Wall Street is doing presently!

Published on  Fri, Sep 5 2008, 08:17 GMT