Many investors (including those who need to make bearish arguments for stocks to please their followers) mistakenly assume that GAAP earnings are preferable to operating earnings. After all, they are “generally accepted accounting principles” so they claim they are more accurate and less manipulative than the non-GAAP operating figures that companies and analysts use. Unfortunately, GAAP earnings are of little help to investors (who job it is to focus on cash flow).

This is because equity shareholders own claims on future cash flow, not reported earnings. Operating earnings are actually much closer to actual cash flows than GAAP earnings because GAAP requires that all non-recurring and/or non-cash charges flow through the income statement, which reduces reported earnings (this is why GAAP numbers are almost always lower than operating numbers). Conversely, operating numbers typically focus on cash profits (with some exceptions… depreciation and amortization being the big one).

Some of the more common bookkeeping entries included in GAAP earnings would be stock-based compensation costs, goodwill impairment charges, asset writedowns, unrealized gains and losses on investments, and one-time restructuring charges such as severance for laid off workers (this last one is a cash item but would not typically reduce one’s estimated value of a company).
These are required to be booked as “losses” under GAAP even though the firm’s financial position is unaffected in all but the last example (because no cash changes hands).

I recall that in late 2007 Sprint wrote down the value of its goodwill by $30 billion (from their il-advised acquisition of Nextel) and that single non-cash accounting line item dramatically impacted the GAAP earnings for the entire S&P 500 index! If you get a few of these in a single year, the numbers can vary a ton. Just looking back at 2008, S&P 500 operating earnings are $49 but GAAP earnings were $15. The same numbers were $57 and $51, respectively, for 2009. Based on that it is easier to see why people would think that 2009 earnings growth of 16% (57 vs 49) was more accurate figure than +240% (the GAAP figure — 51 vs 15).

Hope that helps…

Why assume we go back to the 70s level of 7x? Interest rates and inflation were double digits. We’re at lowest inflation and lowest interest rates in 50 years.

M3? There is no falling M3. The US govt no longer tracks M3 and the so-called “shadowstats” makes up their own estimate of it.

“rotten edifice?” Quality of life has improved in America every decade since its inception which is why our economy is bigger than the next 4 combined.

Take Chad’s number and now back out the cash on the books. Now we’re at a 10-12 P/E for S&P 500 depending on what estimate you use for 2010. The balance sheet of US corporate America is the best its ever been. Should XOM trade at 2x earnings next year? You can take that bet but I won’t (and Warren Buffett doesn’t).

The $82 estimate for S&P 500 earnings includes bank earnings, which, due to changes in FASB accounting rules, are extremely suspect.

I don’t have the data in front of me, but I do know that the S&P 500 traded near 7 times ttm earning at points in the 1970s. Knock $10 off earnings to account for government sponsored accounting gimmicks for the banks and apply a P/E of 7 and you get a number around 500.

I am not saying the index will go there, but there is room for plenty of downside. What of the falling M3? The economy is badly structured, what with annual capacity for 2 million homes and 18 million cars. I don’t see the necessary restructuring taking place. Instead the federal government and central bank are attempting to prop up the rotten edifice.