Why Bears Focus on GAAP Earnings, & Why I Don’t

A very popular argument you hear from the bears these days is the fact that many market strategists are basing their stock forecasts on what are called “operating earnings.” Since third quarter earnings season is in full swing this week, I thought I’d take a moment to give you my views on “operating” earnings and the comparison with the bears’ preference, “GAAP” earnings.

First of all, let’s clarify the difference between the two measures. GAAP stands for Generally Accepted Accounting Principles. These are the rules that accountants use when creating financial statements for corporations. However, just because accountants prefer GAAP, that does not mean that stock investors should necessarily care as much as they do about GAAP earnings.

Investors often create their own measures of value based on what they truly care about when investing in publicly traded businesses, namely cash flow. For example, capital intensive businesses are typically valued on EBITDA, or earnings before interest, taxes, depreciation, and amortization. EBITDA is usually simply called cash flow.

Moving back to the market in general, 2007 estimates call for the S&P 500 companies to earn $93.50 in operating earnings but only $86.00 under GAAP. If you find a 16 P/E appropriate, for instance, you can surmise a fair value on the S&P 500 of either 1,496 or 1,376, depending on which earnings number you use. If you are a bear and are trying to convince people that stock prices are overvalued, which number are you going to use? Obviously, the latter since it is 8% lower.

One of the larger components that accounts for the difference in GAAP and operating earnings is the expensing of stock options. As many of you know, the accounting industry has mandated that companies treat stock option grants as expenses, and reflect that on their GAAP income statements. Since operating earnings focus on actual cash flows from operating activities, they exclude options-related expenses because it doesn’t actually cost a company any money to issue stock options to their employees, even though those options may have monetary value to the holder in the future. GAAP rules account for the expenses to differentiate between firms that issue options and those that do not.

Personally, I have to disagree with the accountants on this one. If booking imaginary expenses for option grants was supposed to show investors that two firms with different compensation structures are indeed different, then they have ignored the fact that the effects of issuing options do show up on the income statement already for all publicly traded companies; under “earnings per share.”

Issuing options does not in any way change the amount of profit a company is earning. As a result, I think it is silly to pretend that it does by expensing them. What is does do, however, is dilute existing shareholders by increasing the total shares outstanding of a corporation. Two companies that are identical in every way except their use of options (or lack thereof) will report different earnings per share (EPS) numbers. The company that issues no options (and thus has no so-called expense) will report higher EPS than a company that issues options, assuming all other factors are equal and held constant.

In my view, that is where investors can differentiate between options issuing firms and those who shun the practice. The dilutive effect of issuing options does in fact show up on the income statement, you just have to move further down the page to see it.

As long as companies that issue options have lower share prices than those that do not (again, assuming all other factors are equal and held constant) there is no reason to pretend that it is actually costing a company real money to issue options. If you do, then the dilutive effect is counted twice (lowering net income once by calling options an expense, and a second time by reducing earnings per share on that lower net income figure via higher share count).

That hardly seems fair to me and as a result, for companies that issue a lot of options (tech companies, for example), in my view it is perfectly fine to use non-GAAP earnings when valuing stocks.