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.

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

  1. I bet you opened a can of worms by taking a stand on the options debate. I take the other side of the argument picking up on your example. Now, assume the option issuing company in your example issues deep out of the money options (i.e. anti-dillutive), then the two companies will have the EXACT same EPS, even though option issuing company has given some value to its management. To me, this underestimates compensation expense.

    Think about it another way: Assume you have two identical companies in every way, except one pays its management an extra bonus of X shares of stock each year. We all would agree with the GAAP treatment that would expense this STOCK grant, and the stock issuing company’s EPS will be lower due to the dillutive effect of issuing the stock. See my point? They are seemingly being hit twice by issuing the stock, once for the expense and once for the dillutive effect. Why are options any different?

    In my book, any time a company transfers anything of value it is an expense. In the case of options the company is transferring options that have a value (and should be expensed) that are a claim on future earnings (and are thus dillutive).

    I’m interested in your response to these thoughts.

  2. Chad Brand on October 16, 2007 at 3:41 PM said:

    As long as the discussion is civil, I have no problem opening up a can of worms and having people disagree with me. That’s part of what blogging is all about.

    To your points, I’m not sure I disagree much with them.

    Deep out of the money options will often never be exercised at all, so in that case, they were worthless. If you expense them up front, then you have to show a credit to income if they do expire worthless, if you want to be consistent. If they are exercised in the future, my view really wouldn’t be any different from what I wrote originally. Existing shareholders would be diluted by the amount of the options, and that would be reflected in the share count and EPS at that point.

    As for stock grants, I don’t think they are any different than stock options. Shareholders prefer them because they are easier to value (we can’t really argue about how much 100 shares of a stock are worth at any given point in time) and they can’t be manipulated like options can be.

    I simply view an options grant the same way I would a new stock offering to the public. More stock is issued, owners are diluted, and thus EPS goes down. But it does not show up on the income statement as an expense if you sell 10% of your company to the public and therefore dilute existing investors.

  3. Anonymous on October 17, 2007 at 7:07 AM said:

    Who in are you refering to when you say that Bears tend to use GAAP earnings? Is there a particular person that you are talking about?

  4. Chad Brand on October 17, 2007 at 7:14 AM said:

    I don’t have one particular person in mind, but one of the more common arguments from those who think the market is overvalued is that many bullish investors are calculating P/E multiples using operating earnings rather than GAAP earnings. They contend this practice is artificially lowering P/E ratios, making stocks look more attractive than they really are. If you watch and read enough material in the financial media, you will hear this point made a lot.

  5. Anonymous on October 17, 2007 at 7:30 AM said:

    What is the percentage of the difference between operating earnings and GAAP earnings in the S&P 500 that is accounted for by expensing stock options?

  6. Chad Brand on October 17, 2007 at 7:44 AM said:

    I don’t have that number as of today, but I can tell you that in each of the 3 full years before the expensing rule was put in place, it represented more than $3 per year in S&P 500 earnings. If we use those numbers as estimates, then options represent nearly half of the differential.

  7. Anonymous on October 21, 2007 at 10:17 PM said:

    In my opinion, there is another way to see the option as a true expense:

    – The company could issue options not to benefit an executive, but itself (the company)
    – When the Company executes the option, it earns money
    – And then transfers the benefit to the executive.
    Looking at it this way, it seems the the option is a cost (AND a cash cost)

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