Stock investors of all stripes care about corporate earnings. Fans of fast-growing companies prefer profits growing at a high compound rate, for example, and those looking for undervalued names may covet companies whose stock prices look cheap relative to earnings per share. Lately, the earnings picture for the entire stock market has been more cloudy than ever, frustrating both professional and armchair analysts.
Given the dire economic circumstances of the pandemic-induced recession, corporate earnings expectations for the second quarter were more than grim. And yet, by early August, with nearly 90% of S&P 500 companies posting profits for the quarter ended in June, nearly 82% of them had beaten dismal Wall Street expectations, by nearly 18% in average, according to investment research firm Refinitiv — the highest “top earnings” percentages since Refinitiv began tracking earnings data in 1994.
But exceeding such a low bar is not very encouraging, and the market responded to the better-than-expected quarter with a collective shrug. When the reports are all released, earnings for the quarter are expected to have fallen another 33.9% from the same quarter a year ago, according to Refinitiv. “This kind of slump in S&P 500 earnings won’t turn bears into bulls, especially with high stock valuations and given the current uncertainty around COVID-19,” said Jeff Buchbinder, market strategist at the investment research firm LPL Financial.
The direction of earnings in the second half of 2020 is still hard to guess given the uncertainty surrounding the economy reopening, Buchbinder said. “Until we get a vaccine or dramatic advances in treatments that allow people to return to some semblance of normal life, incomes will be very difficult to return to pre-pandemic levels,” he says.
Making it harder for market prognosticators: About half of the companies in the S&P 500 canceled the forecasts they usually provide for sales and earnings forecasts for 2020. So, with perhaps a little less confidence In their usual forecast, Wall Street analysts expect S&P 500 company profits to fall 23% for the calendar year, followed by a 31% rebound in 2021.
Behind the numbers. As if there wasn’t enough uncertainty, investors should be aware that even in normal years, an analysis of corporate earnings – the primary driver of stock returns over time – is not that straightforward. than it appears from the headlines of the economic news. . In fact, there are frequently two versions of earnings for a given business in a given quarter. If you are evaluating an individual stock, it is important to be clear about which version you are looking at and why.
You might be surprised to learn that the recognition of corporate profits required by law in the income statement of every publicly traded company is often not the version touted in the news. The “official” statement must include GAAP profits, those that adhere to generally accepted accounting principles. The GAAP rules aim to standardize accounting practices for all U.S. businesses, providing a level playing field for companies reporting profits and a way for investors to make comparisons between apples and companies in different industries.
But because GAAP standards require companies to factor certain expenses into their profit figures – costs that company executives say don’t reflect a company’s true operational performance – most companies also report profits. not in accordance with GAAP. Often listed as “adjusted” or “core” earnings, these figures exclude (among others) one-time and one-time charges such as costs associated with acquisitions, litigation or corporate restructuring. This version is likely the one you’ll see in earnings press releases, stock appreciation reviews by investment analysts, and the numbers cited at the top of this article. This style of financial reporting has become ubiquitous: an Audit Analytics study found that 97% of S&P 500 companies included non-GAAP measures in their financial statements in 2017, up from 59% in 1996.
Adapt to the pandemic. In the aftermath of the COVID-19 pandemic, which has shocked the operations of many companies, non-GAAP metrics can be helpful in understanding what is going on at the business, said Adrien Cloutier, global data director at Morningstar for Equity Research. “But you have to watch your step. These adjustments are made at the discretion of management. It’s not the least biased point of view, ”he says.
Even in the less hectic years, the adjustments can be major. Take data analytics software company Splunk, whose shares have returned 52% in the past 12 months. During the 12 months ending January 31, the company recorded a GAAP operating loss of $ 2.22 per share. But after removing stock-based employee compensation (a common convention among small, fast-growing tech companies), legal settlement fees, and the costs associated with an acquisition, among other expenses, the company managed to non-GAAP earnings of $ 1.88. per share.
A large gap between GAAP and non-GAAP earnings doesn’t mean executives are cheating on shareholders, but it could be a sign that you’re comparing apples to oranges if peer companies don’t make the same adjustments. And as pandemic-related spending spills over to earnings this year, it is incumbent on investors to examine management’s reasoning behind the adjustments, said Jason Herried, director of equity strategy at Johnson Financial Group. “Expenses treated as one-time items that are more like regular business transactions are a potential red flag,” he says. Morningstar’s Cloutier recommends looking at how a business has reported profits over time. “A one-time restructuring cost can be a legitimate adjustment. But if a business adapts to restructuring year after year, it’s not a one-off thing, ”he says.
If you’re skeptical about the quality of a company’s earnings, look for other characteristics of financial health, says fund manager Joseph Shaposhnik at TCW New Americas Premier Equities. Firms with net cash flow (total on-balance sheet cash exceeds total liabilities) and consistently high levels of free cash flow (cash profits after spending to maintain and improve the business) are likely to be healthy businesses. “If a business was generating a lot of cash even during the height of the pandemic, you can be pretty sure that it can survive on the other side of the crisis,” he says.
Consider whether the company would be able to service its debt over the next two years if operations remained at depressed second-quarter levels. “Obviously, no business can run indefinitely with a 90% reduction in business,” says Herried.