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The Declining Quality of Earnings

The relationship between earnings and stock prices continues to weaken

William Hester, CFA
October 2004
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Growth in corporate profits and stock prices are showing little correlation this year. Earnings continue their impressive rebound, while prices year-to-date remain flat. During the heaviest reporting periods of the year, prices have actually declined.

This isn't surprising. Since 1950 short-term growth in S&P 500 earnings and market performance show a near-zero correlation.

There's a slightly higher correlation at the company level, but this relationship has also weakened over time. From 1952 through 1994, the correlation between company stock returns and earnings fell from 45 percent to 15 percent, according to research cited in Earnings Quality, a new monograph published by the CFA Institute.

That drop in correlation between stock returns and earnings suggests a drop in the “quality” of earnings, say Patricia Dechow and Catherine Schrand, authors of the monograph and professors of accounting at the University of Michigan and the University of Pennsylvania, respectively.

They define a high-quality earnings number as one that does three things: it reflects current operating performance, it's a good indicator of future operating performance, and it accurately reflects the intrinsic value of the firm.

“Assuming that market values are a good proxy for intrinsic values, the decline in the relationship between earnings and stock returns can be viewed as a decline in earnings quality,” they write.

Losses and Special Items

Why the decline in earnings quality? Dechow and Schrand reference nearly 300 academic papers, most of them linking financial reporting and share performance. Their monograph is the Cliff Notes to the most current thinking on financial reporting trends.

The authors note two major accounting-related shifts that were accompanied by a declining quality of earnings. First, a major increase in the number of losses reported by individual companies. The number reporting losses grew from 7 percent of companies in the 1960's to 30 percent in the 1990's.

Second, “special items” – like restructuring charges, asset write-downs, and merger and acquisition-related expenses – have also ballooned. In 2001, more than 25 percent of companies reported special items, up from 10 percent in 1982.

The spike in losses and special items may be partly fueled by changes in the U.S economy. Technology companies have grown as a share of the economy, while the manufacturing sector – for which Generally Accepted Accounting Principles (GAAP) were originally developed – has shrunk.

According to one study, companies with rising spending on research and development between 1976 and 1995 experienced a decline in the relationship between earnings and stock returns, whereas companies with declining R&D spending experienced a stronger relationship.

Another reason for less reliable earnings may be that accounting rules have become more conservative. Many new rules focus on the valuation of assets and liabilities, say the authors. This has led to recognizing the full extent of losses as early as possible and deferring the recognition of gains in these accounts.

These losses and one-time charges have prompted companies to push a kinder, gentler form of earnings called pro forma earnings. These are profits that don't include all GAAP-mandated expenses.

Pro forma earnings ‘exploded' in the late 90's say the authors. More often than not, this form of earnings downplays charges.

Research suggests that the companies that used pro forma earnings in the late 1990's had more volatile earnings, more special items, and were more likely to have reported losses. And in 70 percent of the cases, pro forma earnings were greater than GAAP earnings. “These results indicate that most adjustments that companies and their analysts make to GAAP earnings are for negative items.”

Accruals

The drop in the quality of earnings has coincided with another trend: the rise in earnings management.

Earnings are composed of cash flows and ‘accruals'. Managing cash flows is a brash form of earnings management because it often requires a change in the operations of the firm, like cutting research and development or boosting sales by offering discounts.

Accruals are a byproduct of accounting, where business transactions are allotted to the periods where they take place. So revenue is recognized in the period in which it is earned and expenses are recognized in the period they are incurred, whether or not cash is exchanged.

The benefit of the accrual system is that it smooths the results of a business. The weakness is that it calls for a number of estimates of what might happen in the future, like how much inventory will be sold at full price or how many customers will pay their bills.

Boosting earnings by boosting accruals is tempting to corporate managers because it temporarily makes the company appear more attractive. According to research by Richard Sloan of the University of Michigan and Scott Richardson of the University of Pennsylvania, the companies that make the most aggressive estimates see a rise in their earnings, attracting analysts and institutional investors.

But as Business Week pointed out in a recent cover story referencing the research: “When the estimates prove overblown, their stocks founder. They lag, on average, stocks of similar-size companies by 10 percentage points a year, costing investors more than $100 billion in market returns. These companies also have higher incidence of earnings restatements, SEC enforcement actions, and accounting-related lawsuits.”

Companies with more conservative estimates have performed better, according to Sloan and Richardson. They found that excess returns were available to investors that bought companies with low amounts of accruals and sold short companies with high amounts of accruals. This is called the Accrual Anomaly.

The temptation to manage earnings reports seems unlikely to change soon. Business Week noted a November, 2003 Duke University survey that found that two out of five corporate financial executives said they would use legal ways to book revenues early if that would help them meet earnings targets. More than one in five would adjust certain estimates or sell investments to book higher income.

When earnings are managed, the true measures of a company's performance usually lie deeper within its financial statements. Here are a few of the findings reported in Earnings Quality :

•  Earnings management is most likely to occur when companies plan to issue new securities or large amounts of insider selling has just taken place.

•  70 percent of earnings management derives from overstating revenues.

•  The persistence of income statement items depends on how high the item is on the income statement (ie. revenues have the highest persistence rates).

•  Although earnings are more persistent than cash flows, earnings backed by cash flows are more persistent than earnings that contain a larger percent of accruals.

•  A growing gap between a company's earnings and its free cash flow brings the quality of its earnings into doubt.

•  Changes in sales, profit margins, and asset turnover are strongly mean reverting. A company with a high return on net assets ratio, profit margin, or asset turnover relative to its industry median tends to have greater mean reversion in these measures.

•  The largest driver of the Accrual Anomaly is an unusually large increase in inventory.

•  Other accounts where managers have ample discretion include: accounts receivable, other current assets, pensions, and property, plant, and equipment.

•  Ratios that are helpful in forecasting changes in earnings per share: the change in inventory relative to changes in sales (an increase in inventory greater than sales may indicate obsolete inventory), the change in sales relative to changes in gross margin (an increase in sales that does not result in a correspondingly large increase in gross margin may indicate increased competition or change in the underlying relationship between fixed and variable costs), the inventory method used (LIFO is a better measure of the true earning power of a company), and the change in sales per employee (generating mores sales per employee is generally viewed as an increase in the effective use of employees).


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