Carl Icahn sees danger ahead.
In a new video, the billionaire Wall Street veteran warns that stock prices and corporate earnings have been propped up by an overly generous Federal Reserve pumping billions of dollars into the financial markets using crisis-era monetary policy. And rather than investing for growth, corporate managers have been employing financial engineering to manufacture earnings per share growth through M&A and share buybacks.
To make matters worse, companies have employed aggressive accounting maneuvers to accurately reporting certain costs from their publicized financial results. These adjusted items include stock compensation, restructuring costs, amortization of intangible assets, and takeover costs.
For most sceptics, the prefered measure of earnings is GAAP earnings. GAAP is short for generally accepted accounting principles. GAAP accounting standards offer uniformity in how companies report their financial performance. But income statements reported based on GAAP don’t always reflect the ongoing performance of a company’s underlying operations. For example, a company may write-down an asset, restructure its organisation, or contribute to its underperforming hedge fund. These actions usually come with large one-time costs that distort company profits and misrepresent long-term profitability. Therefore, a company will also provide an “adjusted” earnings number that excludes these nonrecurring items.
These adjusted numbers, Icahn suggests, inflates perceived earnings. GAAP doesn’t do that.
“If you do GAAP, which is a tougher metric, you haven’t really increased earnings for three years,” Icahn observed. “They have stayed at around $US100 per share for three years.”
None of this is news. However, the warnings have been getting louder.
“The GAAP/non-GAAP S&P EPS ratio deteriorated from 94% during 1Q13-3Q14 to 78% the past 3 quarters,” Deutsche Bank’s David Bianco warned in mid-August.
The twisted part of all this is that earnings per share on a GAAP basis are down in the first half of the year.
“The S&P avoided down EPS in 1H15, up ~2% y/y on non-GAAP EPS, but the GAAP EPS declined by 13% y/y,” Bianco added. “We have always argued that the best EPS measure lies somewhere between GAAP and non-GAAP EPS.”
Even Icahn would argue that GAAP isn’t perfect either. But it does signal that the premium investors are paying for earnings might be higher than thought.
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