Before embarking on a discussion of fundamental analysis (Chapters 6 and 7) a distinction must be made—between what is reported on financial statements and what is real. In fact, if fundamental analysis is to be reliable and accurate, making core earnings adjustments is a necessary first step.
When Standard & Poor’s Corporation (S&P) developed its concept of “core earnings,” the estimate was that the S&P 500 corporations saw earnings overstated by about 30% during the first year the adjustment was calculated.11 The core earnings (or “true economic profit”) of a company may be significantly different than the earnings a company reports under the GAAP (Generally Accepted Accounting Principles) system. What is allowed and what is accurate are not the same, and this is where the problem arises. A 30% downward adjustment affects not only the profitability and equity of a company; it also makes most forms of financially-based analysis useless. For this reason, using the core net profit and core net worth values are a reliable means for applying financial formulas and ratios. Essentially, core earnings adjustments are an attempt to remove non-recurring and non-operational sources for reported profits and reflect the remainder, the core generated from business activity (and not from exchange rate adjustments, capital gains, and accounting elections, for example).
Where do you find these data? Fortunately, S&P calculates the often complex adjustments between reported and core earnings on its CFRA Stock Reports service. The reports for each company, including a 10-year financial summary, are provided by the major online brokerage services free of charge. Charles Schwab, for example, contains a link for each listed company to the Stock Reports and other analytical services. As of 2016, the CFRA Stock Reports format remained unchanged, but the service was acquired from S&P by CFRA Research. This is the title employed by online brokerage services for reporting the S&P data.
S&P devised core earnings as adjustments due to the inaccuracies in how financial information is reported. They made a distinction between three separate versions of “earnings” used in the accounting and corporate worlds. Reported, operating, and pro forma earnings are all used in various ways. The S&P comment regarding pro forma earnings made an important point regarding the rationale for core earnings adjustments:
Originally, the use of the term pro forma meant a special analysis of a major change, such as a merger, where adjustments were made for an “as if” review. In such cases, pro forma measures are very useful. However, the specific items being considered in an “as if” review must be clear. In some recent cases, “as if” has come to mean “as if the company didn’t have to cover proper expenses.” In the most extreme cases, pro forma is nicknamed EBBS, or “earnings before bad stuff.”12
The observation of flaws in how earnings are reported led S&P to devise the concept of core earnings adjustments, which is defined by S&P specifically:
Core Earnings refer to the after-tax earnings generated from a corporation’s principal business or businesses. Since there is a general understanding of what is included in as reported earnings, the definition of Core Earnings begins with as reported earnings and then makes a series of adjustments. As Reported is earnings as defined by GAAP, with three exclusions—extraordinary items, cumulative effect of accounting changes, and discontinued operations, all as defined by GAAP.13
The accounting industry is assumed to be the watchdog of publicly listed companies. Every company trading stock is required to undergo periodic independent audits and produce certified financial statements. For decades, the investing public has viewed this process as its line of defense against fraud and inaccuracy.
The confidence placed in the independent audit is misplaced.
The audit process is not proactive. Many investors assume that the audit is designed to discover and fix problems, but in fact it is a very passive activity. The audit is designed to ensure that the accounting decisions conform to GAAP (Generally Accepted Accounting Principles). These standards are complex and at times contradictory, so in practice the audit team will only insist on changes when accounting decisions are glaringly wrong. Even then, there have been numerous instances in which incorrect or even dishonest accounting decisions have not been reversed during an audit. The extreme case of Enron is only one of many instances where corporations have deceived investors and the independent audit has not fixed the problem.
The reasons are many, including:
In addition, many auditors have always been recruited from client ranks, so an accounting executive may easily end up working for the auditing firm. The Sarbanes-Oxley Act (SOX) places restrictions on audit work by anyone working for a client in the recent past; but this situation only augments the degree of the problem. The failure of the accounting industry to maintain distance between itself and its clients is disturbing.
3.Failure to take the auditing role as a public responsibility. In theory, the audit is independent and it is performed on behalf of the company’s shareholders. In practice, executives and the board’s audit committee decide which firm to hire (or fire) and the auditing industry has not taken its role seriously. The idea that the independent audit is designed to protect shareholders from unethical executives has simply not worked. And SOX has not fixed that problem. Several years after the Enron scandal, the financial news consistently reveals corporate financial problems.
4.A cultural desire to keep stock prices high. Auditors understand that corporations want their stock price to remain high. A CEO and CFO depend on ever-higher prices to earn their incentive compensation. These bonus and option packages often exceed their base pay significantly and represent millions of dollars per year. This creates an obvious secondary conflict for the executive. If earnings fall below expectations this year, the stock price is likely to fall as well. If a drop of several points in the stock’s value represents several million dollars in compensation, it is important. The auditor may not directly conspire with an executive to artificially inflate earnings, but this cultural aspect to accounting is widely understood. When earnings meet expectations, everyone is happy.
The problems of how the numbers get reported are significant. For anyone depending on audited financial statements to perform an analysis of a corporation, this is a disturbing reality. But the numbers do reveal the truth in many ways. The following guidelines help to get around the deception and inaccuracy of audited financial statements:
There is no single, central control of the GAAP system. In fact, it is a loosely organized set of rules, guidelines, and opinions. The two major organizations involved in development of these rules are the Financial Accounting Standards Board (FASB), an independent organization; and the American Institute of Certified Public Accountants (AICPA), the organization overseeing the accounting industry.
Valuable Resource: To find out how the major GAAP organizations function, check their websites: www.fasb.org and www.aicpa.org
The entire GAAP structure is managed by these two organizations, but “GAAP” includes much more. Publications include high-level interpretations, opinions, and research bulletins; guidelines and statements of position; task force publications and practice bulletins; implementation guides; and issue papers, technical practice aids, pronouncements, and accounting textbooks, trade books, and articles.
It is fair to say that GAAP consists of all current opinions, observations and interpretations of how the industry is supposed to work. Change within this complex structure takes time, because any proposed new approach is subject to a lengthy review process on several levels. Within such a highly technical but loosely organized structure, many different opinions exist and justification for a particular interpretation may easily be found. So in spite of its public image, the accounting and auditing industry is far from specific in its determinations. When a senior auditor confronts a decision that seems to not conform to GAAP, discussions with the company’s financial employees may result in (a) a change in the financial outcome, (b) modification of the transaction, or (c) no change whatsoever. It depends on how aggressively the auditor takes a stand and whether or not some justification can be found in the vast publication universe of GAAP.
Because auditors have a well-known conflict of interest in working on both audits and consultation projects for the same companies, the Sarbanes-Oxley Act attempted to inhibit some of the more egregious problems in five ways:
1.The Act set up a Public Company Accounting Oversight Board (PCAOB) to supervise firm practices and, if necessary, to impose sanctions. The Board is a private sector, non-profit organization, but it reports to the Securities and Exchange Commission (SEC). However, the effectiveness of this oversight board is difficult to judge; between 2005 and 2017, 209 sanctions were imposed against accounting firms, a relatively small number considering the tens of thousands of audit activities performed each year.14
Valuable Resource: Check the work of the SEC and PCAOB by visiting their websites: www.sec.gov and www.pcaobus.org
2.Non-audit services were restricted. SOX named many services that auditing firms were no longer allowed to provide for those companies for whom auditing work is also performed. However, this provision has not affected accounting firms’ ability to generate non-audit revenues. In fact, there is no apparent reduction in revenues among any of the large accounting firms since SOX was enacted. Within the first year following SOX, the Big Four firms continued reporting between $3 and $5 billion per year in non-audit revenues.15
3.Auditors have to rotate off accounts. In the past, senior auditors were fixtures in the offices of larger clients. Maintaining objectivity is impossible when people become so familiar with those being audited. SOX requires partners to rotate off accounts within a five-year period.
4.Auditors report to the audit committee, not to financial executives. Before SOX, auditors met regularly with the CEO or CFO and negotiated changes to accounting decisions. This led to many problems, not the least of which was loss of objectivity for auditors themselves. Executives made decisions to hire or fire firms, giving them tremendous control. Now, however, the board’s audit committee makes those decisions and meets with auditors directly.
5.Auditors cannot move into positions with a client’s company. In the past, companies hired financial executives from the audit team directly, so that the current year’s audit was conducted with a recent employee of the accounting firm itself. Under SOX, the auditing firm cannot conduct an audit for any company that has hired a member of senior management from that firm within the past year.
Have these provisions fixed the problems? There remains a widespread cultural attitude in the accounting industry that views past compliance problems as matters of public relations rather than as potential internal flaws. This means that in order to be able to rely on financial statements, you cannot simply accept a certification from an “independent” auditing firm as the last word. Real independence remains elusive. So in calculating valuation and profitability of a company, you need to be able to isolate non-core earnings and make adjustments on your own. CFRA Stock Reports summarize the core earnings numbers, which helps considerably by providing reliable numbers; but going beyond the one-line identification of core earnings, it is also necessary to look critically at (a) the level of adjustments a company needs each year and the trend in those adjustments; (b) the degree of disclosure and explanation the company provides; and (c) efforts to achieve genuine transparency.
It is clear that the accounting industry has no interest in true reform of its practices. It is up to corporations to make meaningful change. For example, it would be simple for corporations to decide to not use their auditing firm for any non-audit work. This may result in short-term problems, but it would send the message to the investing public that corporate management is serious about fixing its own problems.
A core earnings adjustment is necessary when any material expense is improperly excluded from the list of expenses; or when any material revenue is included, but is a one-time event. “Material” simply means that the dollar value of the transaction makes a difference in the outcome of the financial report (the valuation of the company as reported on its balance sheet or the earnings as reported on its operating statement).
Typically, material expenses that may be left off the GAAP-approved operating statement include:
Stock options granted to executive or employees. The stock option is a form of compensation, but under traditional accounting rules, the value of these options was never reported as an expense—even though their value could be huge. So the expense simply vanished and investors had no idea how much compensation executives earned if and when they cashed in their options. Because stockholders have to pay for those options out of the company’s assets, the effect is very real even though it did not show up anywhere. The large dollar value of stock options has led some companies to voluntarily report the expense, and others to do away with options altogether. Gradually, the system is reforming and stock option expense is showing up in some instances.
Contingent liabilities. Many companies might owe a great deal of money to others, while the contingent expense is not shown on the operating statement. For example, Merck (MRK) faced thousands of lawsuits due to the company’s Vioxx-related problems. The court granted awards to Merck shareholders from 1999 to 2004 in a total of $830 million (plus an additional $232 million for attorney fees and other expenses). The final judgment was entered in 2016.16
This is a huge sum of money. However, until a settlement is final, the potential liability is contingent and under GAAP it is not part of a liability section of the financial report. It shows up only in the footnotes. Under GAAP rules, expenses are to be shown in the year incurred, so realistically the expense of losing a lawsuit cannot be recorded until the loss is determined, in the case of a lawsuit, by the court. Nevertheless, it would make sense for companies to set up loss reserves as liabilities and record an annual expense in anticipation of future litigation losses – especially when those potential losses will be large. A formula similar to that used to set up bad debt reserves would mitigate this problem.
Core earnings can also go the other way. Companies may include revenue that will not recur; as a result, these items should be removed from the operating statement:
Capital gains from the sale of assets. When companies sell off assets they book the revenue; however, this is a non-recurring form of revenue and will not recur in the future in the same way that core revenue would be expected to recur. Capital gains are usually listed below the operating net earnings as a form of “other income,” but the question should be raised as to whether the earnings per share (EPS) includes capital gains. If it does, then the EPS is inaccurate.
Revenue from selling operating segments. Companies also may sell off operating segments. For example, in 2002 Philip Morris sold its Miller Brewing segment and booked $2.6 billion in revenue from the sale, as well as gaining a net 27% stake in the purchasing company, South African Breweries. But this was non-core revenue because it was not profit derived from recurring sales of product. In any study of revenue and earnings for Philip Morris (now renamed Altria), earnings have to be restated to (a) remove the non-recurring earnings from Miller Brewing operations; and (b) also remove Miller Brewing revenues from previous years to accurately track remaining revenues into the future. These are large and very significant core earnings adjustments.
Revenue from non-recurring accounting changes. Companies make technical changes in the way they value some of their assets. For example, calculating bad debt reserves or setting valuation of inventory may be changed, affecting earnings during the year the change goes into effect. These are non-core adjustments and should be removed from the recalculated core earnings.
Altering the reported outcome on the operating statement does not negate the transactions. For example, when a company is paid for selling an operating unit, the money received is real. But under core earnings adjustments, these items have to be excluded in order to estimate fundamental trends and to judge how growth is likely to occur in the future. Non-core items distort this analysis; so before embarking on development of any fundamental trends, these core earnings adjustments should be made to ensure consistency in trends and accuracy over time.
Adjusting core earnings is only half of the picture of the problems with GAAP reporting. When revenues and earnings are distorted by non-core transactions, the balance sheet—where assets, liabilities and net worth are reported—is also altered as a consequence.
It may be shocking for investors to learn that some very large liabilities are routinely excluded from the balance sheet. In fact, the balance sheet does not provide an accurate summary of assets, liabilities, or net worth. The accounting standards applied to how these items are valued fall short of what investors should expect. Some examples:
Pension liabilities. The ever-growing pension liabilities of many large corporations are not reported anywhere. General Motors owed billions in its pension liability by the time the company went bankrupt.
Long-term lease obligations. Many corporations enter into long-term leases for their plant or equipment, often going out 30 years or more. These obligations show up from year to year as current expenses, but the contractual obligation—tangible liabilities—are not shown in the list of corporate liabilities, and this reporting is not required under GAAP rules.
Contingent liabilities. Just as expenses may be understated due to contingent liabilities, the liability itself is not reported anywhere except in a footnote of the annual report. In those cases where the contingent liability could be significant, companies should set up a reserve in its liability section and add to it each year; but under GAAP this is not required.
Stock option liability. Stock options granted to executives and employees in past years remain as obligations of the corporation. If those options are exercised, the employee is able to purchase stock below current market value. This dilutes the value of stock for the remaining stockholders, especially since many such transactions involve purchases of stock at the option price and an immediate sale at market price. That difference is an expense to the company, but the liability does not show up anywhere on the balance sheet.
Asset valuation. Just as liabilities are understated, assets may be as well. Under GAAP rules, depreciable assets are always booked at purchase price and depreciated over a number of years. So while real estate net values on the balance sheet decline each year due to depreciation (until their book value is zero), market value may be rising substantially. This does not show up anywhere. It is commonplace for corporations to own vast holdings of real estate with little or no book value. As a result, GAAP requires these assets to be treated like equipment and vehicles which do truly lose value. Real estate often appreciates, so under GAAP rules, the asset section of the balance sheet is often far below true market value, and the real estimated value reported only in a footnote.
An effort has been underway for many years to resolve differences between GAAP and International Financial Reporting Standards (IFRS), which is used in most of the world outside of the U.S. Many of the IFRS rules, such as valuation of real estate and principles-based recognition rules (as opposed to GAAP’s rules-based approach), are more accurate and less complicated than GAAP; the process of reconciliation has been pursued over many years, but a genuine consolidation is not likely.
The solution to the many material problems in GAAP is to reform the system, but that is not realistic. In order for investors to gain a true picture of the companies whose stock they own, transparency requires a recalculation of asset, liability, and net worth values; and operating statement revenue and earnings. Companies could easily summarize their results in two columns. The first column would be the GAAP-based outcome you see currently, and the second would be the core valuation (balance sheet) and core earnings (operating statement). However, the assignment of accurate valuation is more complex than just making a side-by-side comparison, and opens up the possibility of manipulation.
The importance of core earnings and core valuation adjustments cannot be overemphasized. In many instances, these adjustments radically change the outlook for corporations. Until reform occurs, investors need to continue performing their own fundamental analysis, but with accurately adjusted valuation. When you determine a number of important ratios, both core earnings and core valuation questions have to be addressed, especially when those adjustments are large. For example, earnings per share (EPS) is considered a key ratio and is widely used as a means for judging the value of a stock. The formula:
N ÷ S = E
N = net earnings
S = shares outstanding
E = earnings per share
| A1 | net earnings |
| B1 | shares outstanding |
| C1 | =SUM(A1/B1) |
The shares outstanding is computed at an annual level throughout the year (compared to earnings for the entire year). For example, if a company reports 5.218 million shares and its latest year’s earnings were $1.185 million, then EPS would be:
$1.185 ÷ 5.218 = $0.23
If the number of shares changes during the year, one of two methods are employed for the EPS calculation. First, the average number of shares can be calculated and applied. Second, the entire year’s earnings can be expressed on a per-share basis according to the number of shares outstanding at the end of the fiscal year. The first method is preferred. Since earnings are reported and analyzed on a quarterly basis, any change in the number of shares also changes EPS. Even though this adds more work, the accurate method is to calculate actual average shares for each quarter and throughout the entire year.
A second issue is raised in comparing reported earnings per share to core earnings. If the core earnings are considerably lower, then the EPS is distorted. For example, consider the effect on the above calculation if core earnings were $0.202 million:
$0.202 ÷ 5.218 = $0.04
The difference between 23 cents per share EPS and four cents is considerable. This is not an exaggerated example. It is based on the 2005 results for Lucent Technologies (LU). The calculation of core earnings per share (CEPS) is:
(N ± A) ÷ S = C
N = net earnings
A = core earnings adjustments
S = shares outstanding
C = core earnings per share
| A1 | net earnings |
| B1 | core earnings adjustments |
| C1 | shares outstanding |
| D1 | =SUM(A1-B1)/C1 |
For example, net earnings and core net earnings might appear as:
($1.185 – $0.983) ÷ 5.218 = $0.04
The adjustments may either increase or decrease the reported net earnings. In this example, a reduction occurred, so the adjustments were subtracted from earnings.
The difference between EPS and core EPS can be substantial. For example, someone considering a purchase of shares might review EPS and conclude that the company has consistently produced profitable results. But when the core numbers are studied, the picture is far more dismal.
Two additional ratios should also be adjusted to ensure the accuracy of fundamental analysis. The debt capitalization ratio is among the most important tests of a company’s ability to maintain a balance between equity and debt. But what about unreported liabilities? For example, General Motors’ reported common equity at the end of 2005 was $14.597 billion; but its unrecorded pension liabilities were about $37 billion. The effect of this was that GM’s negative net worth was over $22 billion.17 This profoundly affected the debt capitalization ratio, in fact throwing the calculation into complete disarray. GM’s reported debt capitalization ratio at the end of 2005 was 91% (2001 through 2005 showed the ratio growing from 79% up to 91%, increasing every year). The “core net worth” of GM was obviously negative if pension liabilities were counted. In recalculating the debt capitalization ratio, net worth is a key element to the adjustments. In the case of GM, the ratio could not be calculated because net worth was negative. To recalculate the debt ratio to the core debt to capitalization ratio, make adjustments to total capitalization (which consists of net worth and long-term debt):
L ÷ (T ± A) = C
L = long-term debt
T = total capitalization
A = core valuation adjustments
C = core debt to capitalization ratio
| A1 | long-term debt |
| B1 | total capitalization |
| C1 | core valuation adjustments |
| D1 | =SUM(A1/((B1-C1)) |
For example, assume long-term debt of $3.007 million, total capitalization of $7.382 million, and core valuation adjustments of $1.653 million:
$3.007 ÷ ($7.382 – 1.653) = .52
In this example, adjustments were subtracted. In other cases, the adjustment may involve adding to capitalization for core items.
The same type of adjustment can be required for the P/E ratio as well. P/E is calculated by dividing the current price per share of stock by the EPS. But recalling the dramatic difference between EPS and core EPS in many instances, adjustments can alter the outcome. An organization not showing substantial pension liabilities, contingent liabilities, and similar items on its balance sheet is reporting inaccurately to shareholders and regulators.
These off-balance-sheet liabilities affect virtually all ratios you would perform in trying to place any kind of value in the stock of a company with large adjustments. It brings into question the calculation of earnings as well. Since pension liabilities can represent rather large annual expenses—which also remain unreported on the company’s operating statement—the P/E ratio is inaccurate as well. Numerous adjustments to earnings further affect the earnings used in the P/E. To calculate the core P/E ratio:
P ÷ (E ± A) = C
P = price per share
E = earnings per share as reported
A = core earnings adjustments
C = core P/E ratio
| A1 | price per share |
| B1 | earnings per share |
| C1 | core earnings adjustments per share |
| D1 | =SUM(A1/(B1-C1)) |
The adjustment is shown in the formula as a reduction. Core earnings per share may also be increased for core earnings adjustments. Changes in P/E due to recalculated earnings can be significant. For example, if earnings were reported at $4.55 per share and core earnings adjustments were $3.15, an adjustment takes core EPS down to $1.40. If the current stock price was $92 per share, P/E is first calculated as:
$92 ÷ $4.55 = 20
However, with the core adjustments, core P/E is changed to:
$92 ÷ ($4.55 – $3.15) = 66
Rather than the GAAP-based P/E ratio reflecting that current price represents 20 years of earnings (well within what is considered an acceptable range), the actual core P/E is more than three times higher with price equal to 66 years of earnings, indicating that the stock is extremely overpriced.
Any ratio—including the P/E—is only as valuable as the information used. If P/E is to be used to estimate future trends in stock and corporate value, the core P/E should be the ratio of choice.
Adjusting any ratio involving values reported on the balance sheet or income statement will also affect net worth. An accurate net worth value should be reported accurately with core earnings adjustments. To arrive at the core net worth of a corporation, it is necessary to adjust the reported value of both assets and liabilities. Because this may involve a great amount of detail, identifying the major adjustments may be enough. The formula for core net worth is:
N ± A ± L = C
N = net worth as reported
A = adjustments to reported value of assets
L = adjustments to reported value of liabilities
C = core net worth
| A1 | net worth |
| B1 | adjustments to assets |
| C1 | adjustments to liabilities |
| D1 | =SUM(A1+B1-C1) |
The formula sets up assumed increased in assets and decreases in liabilities. These adjustments can go in either direction. For example, net worth was reported for the most recent fiscal year in the amount of $13,667 (in millions). Adjustments to assets require adding $10.68 and to liabilities requires adding $2,005.05 (both in millions of dollars). Core net worth is:
$13,667 + $10.68 – $2,005.05 = $11,672.63
In this example, net core is adjusted significantly due to the core adjustments to assets and, even more so, the core adjustments to liabilities. Inconsistencies and exclusions of GAAP apply to all corporations and to all years. With this in mind, trends need to be evaluated not only in the current year but as part of an ongoing trend over many years. An evaluation of a 10-year record of a company’s reported statutory (precore adjustment) stock price, debt ratio, revenues, and earnings might reveal potentially significant adjustments.
A symptom of problems involving adjustments to core net worth is also found in the core earnings adjustments. It is a fair assumption that companies with large core earnings adjustments (from reported earnings to core business-based earnings) are also likely to have large core net worth adjustments. As a general rule, companies with relatively small core adjustments also tend to report less volatility in stock price trading ranges. The fundamental (financial) volatility reflected in core adjustments translates to a corresponding high or low volatility level in the stock price; and this itself is a key indicator. An evaluation of volatility in financial reports is discussed in greater detail in Chapters 6 and 7; calculating return on capital can be elusive with core adjustments in mind.
This raises another question: Even if you accept the reported value of net worth as accurate, what number should you use for net profits? Most analysts accept the reported net earnings on the company’s income statement as the accurate number; but a company-to-company comparison will be far more accurate and reliable if, instead, you use the reported core earnings for the year.
The importance of using core earnings in place of reported earnings will also affect how return is calculated. The non-core earnings may be very real in terms of profit and loss, but cannot be relied upon over the long-term as a summary of non-recurring results based on a company’s core business and excluding all else. So restricting your analysis to core earnings, an analysis of return on equity also becomes inaccurate unless adjustments are a part of the calculation. The following revised formulas accurately adjusts “core” return on equity:
C ÷ E = R
C = core earnings (profit) for a one-year period
E = shareholders’ equity
R = core return on equity
| A1 | core earnings |
| B1 | shareholders’ equity |
| C1 | =SUM(A1/B1) |
For example, the net profit adjusted to reflect core earnings for the most recent fiscal year equaled $2,774. Shareholders’ equity is $56,405. Core return on equity is:
$2,774 ÷ $56,405 = 4.9%
A closely related and popularly used formula is return on total capitalization. To adjust this to reflect the core return, a new formula is needed:
(C + I) ÷ (E + B) = R
C = core earnings (profit) for a one-year period
I = interest paid on long-term bonds
E = shareholders’ equity
B = par value of long-term bonds
R = core return on total capitalization
| A1 | core earnings, one year |
| B1 | interest paid |
| C1 | shareholders’ equity |
| D1 | par value, long-term bonds |
| E1 | =SUM((A1+B1)/(C1+D1)) |
For example, core earnings for the past year was $2,774 and interest on long-term debt was $1,652. Shareholders’ equity was $56,405 and par value of bonds was $51,000. Core return on total capitalization was:
($2,774 + $1,652) ÷ ($56,405 + $51,000) = 4.1%
The detailed calculation of core earnings becomes complex when all of its aspects are explored. In fact, an online search on the subject of core earnings is not especially helpful, and there are no services or shortcuts available for making the calculations.
Standard & Poor’s originally developed this system of adjustments as part of its effort to accurately rate bonds issued by listed companies. It continues to emphasize credit ratings on its own website. However, the CFRA Stock Reports provide a one-line annual summary of net earnings and core net earnings.
As the mood for accounting reform moves forward, investors may hope that corporations will take the lead in disclosure with transparency, voluntarily showing core-adjusted earnings as part of its report to investors. S&P would provide a valuable service to investors by expanding its core reporting to include estimates of core valuation. That would include adjustments for off-balance sheet liabilities like pension obligations; employee stock option debt; the current and long-term liability of lease commitments; and a reserve-calculated expense based on an approximation of the value of contingent liabilities. On its Stock Reports, further breakdowns of key ratios (like the debt ratio, current ratio, EPS and P/E) could also be provided on two levels: GAAP and core.
All of these changes would be valuable to any investor who wants to track the fundamentals accurately. Without core earnings adjustments, it is virtually impossible to make reliable comparisons between companies, even when they are in the same industry.
You will not always find such glaring discrepancies within a single industry. But the chance that the numbers you rely upon—the same numbers certified by an independent audit—may, in fact, be highly inaccurate. With this information as a premise for beginning a program of fundamental analysis, the next two chapters provide explanations for the major tests worth using on the balance sheet and on the operating statement of a company.