Too Many Clocks: Adjusting Earnings Has Left Investors with Too Many Watches to Consult

“A man with one watch knows what time it is, a man with two watches can never be sure.”

The Wall Street community has spent the better part of thirty years finding new ways to exclude unusual items, write-offs, non-recurring expenses, and other inconvenient reductions to net income. This art form reached its most recent high (low?) with WeWork’s community-adjusted EBITDA, which cynics interpreted as accounting shorthand for “we are a high growth company, but you should exclude the expenses needed to generate that growth.” Advocates of this practice claim it provides a more realistic view of a company’s future earning power. Naysayers claim it’s a ruse to explain away a stock’s overvaluation by re-imagining the earnings denominator.

Whatever your philosophical leaning, the practice of adjusting earnings has left investors with too many watches to consult. Stocks may look expensive on one earnings number but cheap on another, and investors need to be aware of the differences in earnings metrics as they try to determine a company’s true economic earnings and valuation. A client inquiry prompted us to look deeper into the topic of adjusted earnings to gauge the slippage between commonly-referenced earnings clocks.

S&P 500 Earnings Per Share

Adjusted earnings are somewhat arbitrary numbers, and we identified four versions of S&P 500 EPS that help tell the story of unusual items and Wall Street adjustments.

  1. Reported EPS (sourced from S&P): This series is the best match for GAAP and serves as our earnings baseline.
  2. Operating EPS (sourced from S&P): This series removes unusual items to represent the notion of continuing earning power, and has the “blessing” of S&P.
  3. Wall Street EPS (sourced from FactSet Estimates database): This series calculates earnings on the same basis that Wall Street analysts use to develop forward estimates, and they appear to be even more generous at excluding expenses.
  4. Forward 12-Month Estimates (sourced from FactSet Estimates database): This series is Wall Street’s estimate for EPS as it stood twelve months before the reporting period ended. We include this to capture the level of optimism that is typically present in forward estimates.

Table 1

Table 1 presents the relationships between these EPS series measured over rolling four-quarter windows through March 2018. Reported EPS is our baseline value set at 100% and each alternative series is scaled relative to that base. The four quarters from December 2008 through September 2009 saw massive write-offs coming from the credit and housing crisis, and these losses created huge spreads between reported and adjusted earnings which badly skew the averages. As such, we present medians, full historical averages, and averages excluding the four quarters specifically affected by the credit crisis.