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by Ben Best
Financial statements can organize accounting data to facilitate decision-making by management and by investors. The way financial data is presented for such decisions may be quite different from the way data is presented to fulfill legal requirements that satisfy tax authorities and other regulators. Thus, companies have increasingly produced more than one financial statement, each intended for a different audience. The "pro forma" financial statements which emerged from the bull market of the 1990s is the most notable example of an investor-directed statement.
The 1980s were the heyday of the use of so-called "junk bonds" (high-risk, high-yield bonds) to finance Leveraged Buy-Outs (LBOs). In a leveraged buy-out the target company's assets are used as security for loans acquired to finance the purchase. Attention became focused on EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization, "operating cash flow") as a means of assessing how well a target company could generate the necessary cash to make loan payments. Highly acquisitive companies increasingly began to stress EBITDA rather than net income. Many investors, suspicious of accounting tricks used to boost earnings came to rely on EBITDA as a superior metric of corporate health -- because cash flow is more difficult to manipulate than earnings. Warren Buffet has been harshly critical of EBITDA, saying that "interest and taxes are real expenses".
EBITDA became a particularly widely-used metric by investors in industries such as media & telecommunications that had high levels of acquisitions that caused GAAP earnings to look distorted because of high goodwill amortization. GAAP also seemed to give distorted results in the cable industry where assets being depreciated actually retained value fairly well. As a proxy for cash-flow, EBITDA gave an indication of how well a company could pay-down debt, make future acquisitions or buy-back stock. And accounting tricks used to minimize taxes did not confuse matters.
The June 25, 2002 revelation that WorldCom had misclassified $3.8 billion of operating costs as capital expenses not only devestated Worldcom's share prices and legal stature, but devestated share prices of whole industries for which EBITDA had been a widely-used metric. Unlike operating cost, capital expenses can be depreciated. Although depreciating operating costs increases net income (and taxes!), the increase in EBITDA is even more dramatic. The argument that EBITDA is a proxy for cash-flow and is less vulnerable to accounting tricks than GAAP took a serious beating.
Pro forma ("as if") financial statements have traditionally been statements based on hypothetical figures used as a means of assessing how assets might be managed under differing future scenarios. In the second quarter of 1998 Amazon.com, Inc began reporting a "pro forma" earnings that excluded amortization expenses on intangible assets (goodwill) associated with the many companies Amazon had purchased with its stock. Amazon asserted that these costs created so much "accounting noise" that true profitability was being masked. Yahoo!, Inc followed suit for the fourth quarter of 1998. Soon hundreds of tech companies were issuing pro forma statements. By the middle of 2001 the majority of S & P 500 companies were excluding certain GAAP (Generally Accepted Accounting Principles) expenses from the earnings figures they reported to investors. Sixty cents on every dollar of S & P 500 company earnings reported for the second quarter of 2001 came from excluding costs that would have been included under GAAP.
Pro forma financial statements are press releases rather than official documents, and are therefore not subject to SEC (US Securities and Exchange Commission) authority, unless they are fraudulent. Some analysts have complained that pro forma financial statements are merely a means of evading the truth according to GAAP -- a kind of "window dressing". But accounting for goodwill can truthfully result in large distortions. Goodwill is defined as the difference between the fair value of an acquired company's assets and the price paid for that company (when the latter is greater, as it usually is). When a company has purchase another company with stock that has fallen an order of magnitude in price, what is the "true" cost of the transaction -- or value of goodwill?
Pro forma financial statements, however, now exclude more items (usually expenses) than just goodwill -- including payroll taxes on employee stock options and an expanding definition of "extraordinary items". Under GAAP, an Extraordinary item is both unusual and infrequent, such as an earthquake in a region where quakes are rare. In pro forma statements, however, extraordinary expenses can include such items as costs associated with layoffs, equity investment losses, inventory write-offs, loan losses and restructuring charges.
Qualcomm, for example, reported substantial revenues on sales to Globalstar during the 1995-2000 period. But these sales were financed in large part through credit from Qualcomm which was ultimately defaulted-upon -- and written off as a one-time expense that was excluded from Qualcomm's pro forma statement issued for the quarter ended 31-Dec-2000. Cisco excluded a $2.25 billion write-off of excess inventory in the pro forma report for the second quarter of 2001. Critics argue that the "big bath" technique of extraordinary write-offs in a single quarter is a gimmick, and that the expense should have been gradually written-off over many past & future quarters. Amazon has been accused of hypocrisy because its pro forma statements excluded noncash expenses while including in revenues noncash sales of services to dot-com customers who paid in stock.
Unlike GAAP, there are no uniform standard which can be applied to pro forma financial statements. But earnings expectations & results have increasingly been reported to Wall Street on a pro forma basis by First Call (a unit of Toronto-based Thomson Financial Corp ). Although First Call has been critical of pro forma accounting, as the foremost agency for gathering & publishing consensus earnings targets it has been forced to accept the accounting practices accepted by the majority of analysts in the investment community. And most analysts have found pro forma accounting to be acceptable.
Claims that pro forma statements are a "snow-job" to make earnings look better must address empirical data by Georgia State accounting professor Lawrence Brown, which indicates that pro forma numbers are in general better guides to perfomance than the GAAP-style earnings filed with the SEC. Brown found that stock prices moved more in response to pro forma earnings releases than to GAAP earnings releases. Also supporting the idea that pro forma statements are a cleaner presentation of data for investor purposes is the finding of University of North Carolina professors Abardbanell & Lehavy that for only 10% of companies do reported pro forma earnings exceed GAAP by more than a fraction of a cent (BARRONS, 6-August-2001, p.30).
The FASB (Financial Accounting Standards Board, the nongovernmental authority which promulgates GAAP) acknowledged the problems with expensing goodwill by revising GAAP ( FAS No.142, effective 1-Jan-2002) to prevent amortizing of goodwill until the goodwill becomes "impaired". Goodwill of an acquired company might become impaired when key employees leave, products become obsolete, patents expire or competitors gain market share. The acquiring company must decide the amount & timing of the impairment. Critics complain that this provision simply allows for goodwill write-offs when convenient and that acquisitions will be encouraged. Reported earnings of S & P 500 companies are expected to be artificially increased by 3-7% for the first quarter of 2002.
The terrorist attacks on the World Trade Center & Pentagon on September 11, 2001 provided many companies with an opportunity to take advantage of "big bath" write-offs on conventional (non-pro forma) accounting statements. The FASB struggled to establish rules for write-offs that could properly be attributed to the attack -- finally abandoning the effort. Techniques for loading losses onto 2001 to make 2002 profits look better included slashing the value of physical assets to reduce future depreciation, overestimating bad debts (boosting profits when customers pay), charging impending restructuring costs immediately and delaying the close of sales contracts beyond year end (so they could be attributed to 2002).
Analogous to the emergence of pro forma earnings from the tech sector has been the disagreement of whether GAAP net income is the best way to represent earnings in real estate. In 1991, the National Association of Real Estate Investment Trusts (REITs) created a standard called FFO (Funds From Operations, which adds back depreciation & amortization expenses on the grounds that real estate generally increases in value over time (unlike vehicles and other machinery). Gains & losses on sales of depreciated properties are excluded. Although FFO became the REIT industry standard, the guidelines aren't binding and some REITs have allowed other inclusions & exclusions in FFO (such as excluding foreign currency losses). In mid-2001 Morgan Stanley, Merrill Lynch and Citigroup's Salmon Smith Barney broke ranks with the REIT industry and declared that they would forecast REIT earnings based on GAAP net income.
Even GAAP net income has recently been subject to increasing dispute concerning pension funds. As of August, 2001, 352 of the S & P 500 companies have defined-benefit pension plans (as distinct from the employee-controlled plans, including 401(k)s). In a defined-benefit plan, a company must estimate the amount of money owing to their pension plans yearly and make contributions as required. But stock & bond returns were good enough -- even in 2001 -- that many companies did not need to contribute to their plans -- and report the difference as net income. An estimated 13.7%, 16.4% and 5.4% of net income for General Electric, AT&T and Ford Motor (respectively) were derived from pension funds in the year 2000 (BUSINESS WEEK, 13-August-2001, p68).
The use of operating earnings (pro forma earnings) rather than net income (GAAP earnings) results in very different estimates of P/E (price-to-earnings ratio) for the S & P 500. In August 2001, the P/E for the S & P 500 was 22.2 based on operating earnings, and 36.8 based on GAAP net income. But it is operating earnings that is now most closely watched by Wall Street analysts & investors. Even with P/Es, it should not be forgotten that accounting P/Es are historical records, whereas discounted cash flows are based on anticipated future P/Es. (For details concerning the S&P 500 and other American stock indices -- see my essay The Major American Equity Indices.)
Many investors, in fact, have focused more attention on revenues rather than earnings. Thirty percent of Intel's year 2000 profits came from its investment portfolio rather than its sale of semiconductors. Revenue growth, by contrast, may be a far better indication of a company's future prospects.
In the 1993-1998 period, earnings-per-share grew at an annual rate of 1% faster than overall earnings. During that period companies bought back 2% of their stock yearly, but half of those shares were new shares created by employees exercizing stock options -- resulting in the 1% difference.
In every year from 1943 to 1960, more than 82% of the NYSE (New York Stock Exchange) companies paid dividends. But by 1998 only a fifth of publically-traded companies paid dividends. Microsoft, Oracle and Cisco Systems have never paid a dividend. Investors were satisfied with capital appreciation -- and the fact that American tax on capital gains is less than the American tax on income from dividends. But with the stock market collapse of 2000/2001 and questions concerning pro forma accounting statements, dividend paying stocks became the best performing investments. A company paying dividends can only do so out of real earnings and cash flows -- particularly difficult in recessions when cash flows get strained.
Superficially, the difference between value-investing (often represented by the Dow index) and growth-investing (often represented by the NASDAQ index) is that the former seeks low P/E ratios. But value investors frequently look much deeper than just the P/E ratios, especially in light of modern accounting practices. Often a company will have a low P/E ratio for the good reason that the company's business prospects are not very good. A record of dependable earnings over a long period usually indicates similar earnings in the future. But companies with dependable earnings are generally those in mature industries where growth prospects are poor. Over the long term, value-investing has not, in general, yielded returns that were better or worse than growth-investing for the great majority of investors (institutional or individual). Warren Buffet has been one of the most successful value-investors of all time on the basis of his ability to assess businesses and compare the prospects of those businesses with their stock prices.
The Tobin "q" ratio, named after Nobel laureate economist James Tobin, attempts to value companies on the basis of a ratio between book value and market value -- narrowing book value to plant & equipment. But intangible assets like patents, copyrights, licenses, trademarks, skilled management and inventive (loyal) employees are often more important than tangible assets.
The Fed model for valuing the market compares the S & P 500 earnings yield (inverse of the P/E ratio) to the 10-year US Treasury bond yield. If the earnings yield is appreciably higher than the Treasury yield then the market is said to be undervalued and the prudent investor is wise to buy an S & P 500 index fund.
The greatest rewards in the shortest periods go to investors that risk funding growth stocks having no earnings. Revenues for Amazon grew from less than $1 million in 1995 to more than $8 billion in mid-2001, while earnings remained negative (even on a pro forma basis). An investor who bought $1,000 worth of Yahoo! shares at the time of the April 1996 IPO (Initial Public Offering, when shares are first publically traded) would have had shares worth nearly $5 million in mid-2000. P/E would have been no guide to this growth because Yahoo didn't report a profit until 1999. New companies with new innovative products and the most astronomical growth prospects rarely have earnings during their start-up phase. Companies that plow their revenues into growth can't be expected to show a profit -- and would grow more slowly (and risk losing market share) if they restrained their growth-oriented expenditures in order to show a profit. If investors have faith in the growth prospects of a company with trememdous growth opportunities, then that company can afford to reinvest cash & earnings without feeling the need to demonstrate earnings (money held rather than spent on expansion).
But an investor may justly question whether the company has the ability to make a profit. For every rapidly growing company that is shrewdly expanding capacity and avoiding the taxes associated with income, there are many other unprofitable companies who are recklessly burning cash and mismanaging assets on the road to bankruptcy. Successful growth investing also requires the discovery of true value.
In the period from 1980 to 2000 the average P/E of American firms was 15, but by 2000 the figure was over 20. Claims have been made that cost of production inputs has declined, that inventory management has improved and that inflation & inflationary instability have been reduced. Output per worker grew at 2.3% annually from 1995-1999 as compared with a mere 1% annual growth in productivity in the 1987-1995 period -- a significant difference that could well justify a higher P/E on the basis of the future growth this production increase would imply. Glassman & Hassett (in their book DOW 36,000) claim that investors have realized that stocks consistently & significantly outperform bonds over the long term (and are therefore less risky) and merit a P/E of at least 100.
Investors have probably become more focused on revenues & revenue-growth because a company with good revenue prospects can always hire management who can bring costs under control, but for companies with poor prospects for revenue growth good earnings usually forebode nothing better than a stable stock price. Historical comparisons are not an infallible guide to true value, especially when the metrics and fundamentals are changing.
(See also my essay The Uses of Financial Statements).
For more on investing/trading strategies, see my essay, Investing & Trading in Equities: Art & Science.