Extraordinary items: to be or not to be - in the investor's calculation of earnings per share? That is the question as we approach earnings season. What difference does it make to the S&P 500 (NYSEARCA:SPY)?
First, a 7.67% increase in the estimated Price/Earnings (P/E) ratio, from 17.6 to a 18.95 Trailing P/E, as of July 10, 2014. The buy side keeps up apologetics to justify a 17ish P/E. However, 19 is another story; any astute investor knows that is historically high and warrants caution.
Hence, the present difficulty facing investors. Excluding extraordinary items, which typically impact negatively to a company's bottom line, can be a useful tool to analysts / investors. If it is truly an one off event then the future earning power of the company should be based on future prospects without this "infrequent" expense. But, what if a company keeps classifying items as "extraordinary" and "below the line" (see power point download from NYU Stern)?
Well, then an investor should be suspicious of the true earnings power of the company going forward. Now, imagine the S&P 500, not as 500 separate companies, but as 500 separate divisions in one company, as a thought experiment. Each division has a manager who can the use "extraordinary" item method in the course of running the business.
Next, imagine the chairman, of this fictitious conglomerate, trusts the managers not to abuse the extraordinary line item power when turning in their earnings; after all it does has a legitimate use.
The managers begin to notice that the chairman does not get as upset when expenses are reported as "extraordinary". Of course this starts off as a legitimate use of accounting methods, but human nature being what it is, the "method" begins to spread.
Some managers, who have less scruples, think they can bend the accounting rules when they have a bad quarter, and keep the chairman off their backs. After all, they can run their division more "effectively", without having to answer questions, go to more meetings, and of course, don't want the employees under them to loose their potential bonuses. "Just don't abuse it every quarter and you'll come out ahead", they reason.
Because of this practice most managers who abuse the accounting rules the chairman does not replace. In turn, this emboldens managers, who would not bend the rules, to take chances of expanding their division. After all, if the expansion fails, from a merger or acquisition (M&A), it can be written off without much fear of reprisal. If the M&A works then the manager's kingdom gets bigger and the potential bonuses get bigger as well.
Over time almost all of the managers know they can use the "extraordinary" method without much risk of getting fired; just don't abuse it quarter after quarter, when the chairmen looks at each division. Both unscrupulous, and managers with scruples, come to accept this as just the course of "doing business".
Each division says that it adheres to GAAP, and that is true. However, as a whole the company has been weakened by more lax accounting standards. When you look at each "tree" (division) it has good and bad periods, but the forest as a whole is less healthy.
Now, how well does the above parable reflect the S&P 500? Here is the data in graph form of the trailing 12 months reported EPS as a percentage of operating EPS.
Source: S&P Indicies (under "Additional Info"), my calculations
Source: Same as above, and note data for Q4 2008 was excluded. The above chart is for only each quarter's data until Q1 2014.
One can see that the data appears to match what happened in the parable. The 95% confidence interval of "EPS as % of Operating EPS" ranges from 85% to 90.3%. This makes it highly likely that the S&P 500's earning power is at least 10% below "Operating Earnings" (data from Q4 2008 excluded in calculations).
What difference does this make to investor's bottom line? Since Q1 1988 investor's have "lost" $193.70 a share from the difference between "Operating EPS" and "Reported EPS". All of the sudden those write offs don't seem so small; and it is time for the chairman to wakeup, see that the company's earning power is not as high as was believed.
P.S. Stay tuned for an article on how to find the justified trailing and forward P/E of the SP-500.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.