The Gap And The GAAP

GAAP – it’s not the clothing store but an acronym for Generally Accepted Accounting Principles, or guidelines for companies to follow when figuring up their financials, including their earnings. It is those earnings that are usually the basis for how much a company’s stock sells for. Public companies report their earnings to the government each quarter according to GAAP principles, and are called net earnings. From these earnings companies pay out dividends to their shareholders.

There is another common form of earnings, called operating earnings, which are higher than net earnings. Naturally, company officers refer to those higher earnings in conference calls to investors each quarter. Operating earnings do give a better sense of the long term viability and profitably of a company. What’s the difference?

Operating earnings are what’s left after paying employees, material costs and operating expenses, lease or loan payments and depreciation on buildings and equipment and so on. There are two costs that it doesn’t account for: taxes and interest. Net earnings are lower because that’s what left after paying taxes and interest. Net earnings will also include adjustments for what are called extraordinary items: one-time expenses that should not be recurring.

In a 9/18/09 “Ahead of the Tape” WSJ column, Mark Gongloff reports that the gap has narrowed between these two measures, operating and net earnings. The gap was about 2% and that narrow gap signals stability – for now. Mark notes that the last time the gap was this narrow was in the quarter ending March 2000. What he doesn’t mention is that, shortly after that date, the stock market started a long swan dive. Over the past 15 years, the cumulative gap between these two earning figures has been increasing each quarter. From past experience, we know that the gap widens during a recession. I suspect that this long term trend shows that there have too many aggressive accounting tactics so that management could paint a rosier picture of a company’s future earning potential, thus driving up the price of the stock.

Lastly, these two measures play an important part in evaluating the price of a stock. The P/E ratio, a common yardstick to measure stock price, is the price of a stock divided by the earnings per share. There are two common P/E ratios: TTM, or stock price divided by earnings during the trailing, or past, twelve months; and forward P/E, which is the stock price divided by the estimated earnings for the next twelve months. However, the two P/E ratios are based on two different earnings. The TTM ratio is based on net earnings. Forward P/E is based on estimates of operating, not net, earnings. Even if estimates prove to be accurate (which is unlikely a year in advance), the net earnings will be lower when they actually happen. If a 2% gap in these two measures is unusual, then a cautious investor might add another 4% to a estimate of future P/E to get a more realistic estimate.

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