The first valuation method most investors learn is the humble Price/Earnings (P/E), as in theory it’s both easy to calculate and easy to compare across companies. Unfortunately in my experience, this is a long way from the truth due to the lack of consistency in the earnings number used.
The reason is that companies take full advantage of the significant discretion they have in calculating their highlighted earnings number (which is calculated on an ‘Adjusted’ or ‘Non-GAAP’ – Generally Accepted Accounting Principles basis) and unsurprisingly many management teams use this flexibility to boost their announced earnings.
This also makes comparisons between companies much harder because there is a lack of consistency in the adjustments made. For example, 43 companies out of the S&P 500 in 2014 chose to exclude the cost of stock options from their Non-GAAP earnings boosting their aggregate profits by $13.6bn; however, 457 companies took a different view and accepted that it was a cost of doing businesses and deducted it from their earnings.
There are also different approaches on a number of other accounting items such as restructuring charges, intangible asset writedowns, litigation costs and pension fund fair-value adjustments. Whilst these items sound pretty dry, the crucial point is that in aggregate, the adjustments materially change the earnings number. On average across the whole S&P 500, these adjustments boosted profits by 16%, but this hides the fact that there are some companies making very material alterations.
This impacts the P/E because rather than the heavily regulated GAAP earnings number, it is the lightly regulated, Non-GAAP number which has become the main denominator in the calculation. Company management teams are therefore incentivised to positively adjust their declared earnings number through both their share option exposure (as many investors do not make the required adjustments and these adjustments can, in the short term, inflate the share price) and their bonuses when these are based on a performance criteria (typically based on Non-GAAP earnings).
At a sector level we see a clustering of approaches. Once one or two companies start excluding various charges their peers tend to follow or they risk looking ‘expensive’ on a P/E basis. Thus it is relatively common practice for IT companies to exclude stock options from their Non-GAAP earnings (it contains 32 out of the 43 companies in the S&P 500 that make this adjustment). Frustratingly however, there will always be outliers in each sector.
Perhaps surprisingly, whilst the IT sector contains many of the companies that exclude stock options, work conducted by Deutsche Bank shows it’s been the healthcare sector that has made the greatest level of adjustments (over the last five years GAAP earnings have only been 77% of Non-GAAP). This is primarily the result of excluding high stock option grants in biotechnology companies and consistently large annual restructuring charges in the pharmaceutical companies.
There are also complications at an index level. In 2014, the S&P 500 GAAP earnings was $102 whilst the widely used IBES Non-GAAP earnings was $118 (based on analyst consensus with little attempt at normalising the assumptions). A number of data providers such as S&P and Bloomberg attempt to calculate earnings based on a consistent methodology producing probably the most useful analysis. The chart below shows how these different definitions produce a range of S&P 500 EPS values.
Does any of this matter?
In my experience it does and it’s worth putting in the time to look at the adjustments each company makes. The market does tend to be relatively forgiving of the adjustments but I do not believe this to be sustainable. Due to the size of the adjustments, pressure is likely to build and companies will need to be more consistent leading to potentially marked differences in share-price performance. I’ve also found that companies that are aggressive in their adjustments tend to be aggressive in other areas of their business. I don’t want to write off the P/E, its simplicity has clear attractions, but it’s vitally important to question how it has been calculated whether looking at a stock, a sector or a market.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.