How Much Can You Trust Earnings Numbers These Days?

by Inya Ivkovic, MA

Research analysis dogma swears by the price/earnings (P/E) ratio. Only, you can’t have the P/E ratio without earnings. So, how about one of the prize benchmarks, the S&P 500, not having any?

No, I haven’t lost my marbles and I’m not referring to the popular net income as the gauge for calculating the P/E ratio. Rather, I’m referring to something called “comprehensive income,” which, while not exactly widely known, except perhaps among accountants, is a far more inclusive measure of profitability. It also has a well-defined, standardized meaning, which is the change in a shareholders’ equity during a certain period, excluding the effects of new capital infusions and dividends.

Having comprehensive income occupy the place of the denominator in the P/E fraction, in late March, S&P 500 companies had aggregate losses for the past four quarters of approximately $200 billion. In other words, there is no price/comprehensive income ratio because there is no income. In contrast, for the same period, S&P 500 companies reported net income of about $295 billion in aggregate. Roughly, this translates into a P/E ratio of about 25 times earnings for the index. In my book, that’s too much money to pay for companies whose earnings look good only on paper.

So, here is this week’s due diligence advice to our readers — start paying attention to comprehensive income. Net income is not a bottom-line kind of gauge, as it is portrayed. Over the years, net income has become one of those polluted accounting categories that are no longer a reliable measure of a company’s profitability or lack thereof. Why is comprehensive income a more reliable gauge? Simply because it contains items that management does not want you to know about. Unfortunately, things are about to get even murkier.

Starting with the first quarter of 2009, succumbing to pressures from the banking industry and the hands that feed it in Congress, the Financial Accounting Standards Board has agreed to let companies avoid reporting the brutal, long-term price declines of debt securities they own. Previously, the moment companies realized that such losses were no longer temporary, they had to be recorded in the net income. And that’s on top of other exclusions, such as gains and losses from retired employee benefit plans, certain derivative contracts, and foreign exchange gains or losses. However, all of these items will continue to be included in the comprehensive income.

The gap between net income and comprehensive income has never been wider than it is today. The bloodbath of last year has taken its pound of flesh from nearly everyone, and then some. At some companies, the gap between net and comprehensive income in 2008 was enormous.

Of course, no accounting measure is perfect. Comprehensive income has its flaws as well. For starters, it depends to an extent on subjective estimates, ranging from how revenues are recognized, to how loan-loss reserves are estimated, to which method is used to calculate depreciation of fixed assets. That said, however, comprehensive income is also the closest an investor can get under GAAP to a clear picture about a company’s profitability.

The biggest challenge with comprehensive income is actually finding the figure in the mess of financial reports flooding the press every quarter. Although companies are obligated to disclose comprehensive income, the figure is not likely to be neatly summed up on income statements. Instead, you can find it on the statement of shareholders’ equity or hidden somewhere safe in the footnotes. So, you’ll have to look for it and it’s not going to be easy, but comprehensive income figure is not a needle in the haystack and it will give a world of necessary information to make educated decisions about your investments.