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Commentary > The Bottom Line
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Pricey stocks just got pricier
If S&P's new measure of earnings takes hold, valuations will seem a lot richer than they already do.
May 20, 2002: 5:02 PM EDT
By Adam Lashinsky, CNN/Money Contributing Columnist

PALO ALTO, Calif. (CNN/Money) - As the Bard penned, in "Romeo and Juliet," "A rose by any other name would smell as sweet." The question before us today is whether earnings, as recently redefined by the gentle people at Standard & Poor's, will lead to more sour valuations for stocks.

At issue is S&P's much-heralded announcement last week that it will now emphasize what it calls "core" earnings. This is to be contrasted with "reported" earnings, also known as "GAAP" earnings, for generally accepted accounting principles; "pro forma" earnings, or earnings before all the bad stuff; and "operating" earnings, another "as if" measure that primarily gives investors a view of financial performance as if taxes, debt payments and regular asset write-downs didn't exist.

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The financial-services industry spent the last half of the last decade creating goofy measurements for stock valuations and finding ways to spin their clients' financial situation. Now the stern folks who act as interpreters between companies issuing stocks and the people who own them are busy coming up with a new language to do the explaining. Witness belated efforts by Charles Schwab simply to introduce an understandable scheme to rate stock picks, as noted here Friday.

S&P's "core" earnings exclude from reported income items like earnings from discontinued operations and other extraordinary fare like impairment charges related to goodwill, gains from pension funds and asset sales.

They will include important matters like the costs of acquiring R&D, restructuring charges directly related to ongoing operations and the one that sends shudders down the spine of Silicon Valley, expenses related to granting stock options to employees.

The changes undoubtedly will have the effect of decreasing earnings -- by as much as 10 percent, S&P guesstimates. If you're still wondering whether this matters, the answer is -- in the best Upper Plains states accent you can muster -- You betcha'.

As one of my better hedge fund sources relates, it's not as if investors will suddenly see stocks as more expensive and rush to sell. After all, investors who care about such things have already been ignoring extraordinary accounting sleights, and not worrying about whether "pro-forma" earnings beat by a penny.

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But S&P is an important data provider, and there's something to it putting out "core" earnings for everyone to see. CEOs of affected companies will alter their behavior, my source speculates. If stock options are to be counted on the bottom line, they'll either have to watch their earnings diminish or, gasp, reduce the outflow of stock options. Fewer options in turn might just pop the Silicon Valley real estate bubble.

The additional dominoes that could fall are many. As an example, my source notes that chip-maker Broadcom is chugging along losing around 6 cents per quarter in these tough times. Were that loss to broaden to 30 cents because of option-related expenses, Broadcom's stock could get similarly hit.

I'm betting stocks won't smell nearly as sweet when they're given a new name. It turns out many of yesteryear's seemingly fragrant strains merely were garden-variety shrubs in disguise.


Adam Lashinsky is a senior writer for Fortune magazine. Send e-mail to Adam at adam_lashinsky@timeinc.com.

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.