Readers will be familiar with my view that we are now in an earnings recession— year-over-year S&P500 earnings are now down three quarters in a row and I’m confident we are headed for more.
But there is a second earnings issue besides the slope of the trend that bothers me just as much. The accounting profession has something called GAAP—Generally Accepted Accounting Principles–which set the standards for how earnings are calculated. GAAP has rules about recognizing revenue, what is expensed, depreciation, tax reporting and so on. The result is a final number that can be compared against the past and against other companies.
At the end of every boom (like now), these standards are increasingly ignored in favor of reporting non-GAAP earnings. What are non-GAAP earnings? The short answer is just about anything you want. Or as one accountant friend puts it, “earnings without the bad stuff”. And at the end of every bust, companies get religion and go back to GAAP to try to win back the confidence of investors. But in the meantime, Wall Street analysts go along with non-GAAP reporting because it makes everyone feel good.
What bad stuff gets left out? Well, stock based compensation for one; it should be expensed as compensation but often is not. Or inventory write-offs and plant closings which seem to happen every year but are slipped out of the earnings calculation as so- called non-recurring items.
How bad is it? The gap between GAAP and non-GAAP has never been wider. Total non-GAAP EPS for the S&P500 are expected to hit $118 for 2015. At an S&P of 1940, $118 implies a P/E multiple of 16.5x.
Now look at GAAP earnings. Using standardized I/B/E/S GAAP earnings (Institutional Brokers’ Estimate System) which excludes pro-forma write offs, add backs, non-recurring items and countless other misleading numbers, you get total S&P500 earnings for 2015 of just $91.5 rather than $118, the lowest S&P500 GAAP earnings per share since 2010. This results in a GAAP P/E above 21, the highest since the financial crisis.
So what is going on here? The growing decline in earnings is being hidden from you. The blue bars tell the tale. At some point, the overstatement of earnings will become clear. It will not be a good day for shareholders.