When an Earnings Treat Is Actually a Trick: 2 Misleading Figures to Look Out For

By TradeSmith Research Team

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Third-quarter earnings reporting season is upon us. And investors are bracing for impact.

That’s because Wall Street analysts have been busy slashing earnings per share (EPS) forecasts for S&P 500 stocks by the most since early 2020 during the COVID-19 stock market crash.

It’s really no surprise, given the declining U.S. economic growth in the first half of this year. Plus, analysts do typically trim their EPS forecasts just before quarter’s end. In effect, they lower the bar, making it easier for companies to beat by a penny or so.

But still, recent cuts have been deeper than usual.

In fact, analysts cut EPS estimates 6.6% over the past three months. That’s twice as much as the typical estimate cut of 3.3% on average over the past 10 years.

Prior to the monster earnings decline during the COVID-19 pandemic, the last time EPS estimates were cut so deeply was during 2019, as you can see in the chart above.

Then, like now, the Federal Reserve was aggressively raising interest rates, and markets worried that the Fed might tighten us right into a recession.

A recession almost always means falling corporate profits, which is why Wall Street is lowering forecasts so deeply, trying to stay ahead of the curve.

The current forecast from the Street calls for EPS growth of just 2.4% for the third quarter of 2022. That’s down from 9.9% expected profit growth as of the end of June.

If that’s the final number, it will be the slowest quarterly profit growth since stocks were still recovering from COVID-19 in the third quarter 2020. And the biggest culprit for the EPS cuts is… you guessed it, rising costs.

In the earnings reports that have been released so far this quarter, labor costs and supply chain disruptions and costs have been the two most common factors that companies have cited as negatively impacting earnings results.

As for individual sectors, energy stocks are forecast to deliver the best profit growth at 117% over third quarter 2021, according to current estimates. Other sectors with better-than-average profit growth expectations include Industrials, Real Estate, and Consumer Discretionary.

But here’s a word of caution heading into this batch of earnings reports. You shouldn’t take everything companies say about earnings at face value.

Along with slowing EPS growth comes a growing incentive to fudge the numbers a bit. And there are all kinds of EPS tricks that S&P 500 companies have up their sleeves.

Here are two of the most frequent tricks used today that you should watch out for.

EPS Trick No. 1: Adjusted Earnings

Public companies, especially those with no real EPS, have a love affair right now with something called adjusted earnings. Take those figures with a big box of Morton’s salt.

There are plenty of young, fast-growing companies today (mostly technology related) that are not yet profitable according to generally accepted accounting principles (GAAP).

GAAP isn’t perfect, but it’s the standard that most big, established companies use to present their financials. Other companies, not so much.

Some of these companies figured out that if they make enough adjustments to GAAP EPS, they can appear profitable on paper.

This embellished figure is labeled “adjusted earnings.” Sometimes called non-GAAP earnings or adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization), it’s an epidemic on Wall Street today.

To create the appearance of profitability, companies take what is supposed to be bottom-line net income (or losses) and then add back non-cash expenses like depreciation and amortization to their earnings. And presto, they come up with much better adjusted earnings.

This is widely done with intangible assets and things like software and equipment. GAAP clearly says you should write off the value of these items over time.

But if instead you simply add them to your earnings, you can adjust your way to profits!

EPS Trick No. 2: Stock-Based Compensation

Another popular trick is a line item called “stock-based compensation.”

This is when companies (often tech companies) decide to add back the cost of stock grants and stock options that they use for employee compensation. And stock-based compensation can easily run into the hundreds of millions or even billions of dollars.

So, if you hire workers and pay them a salary or an hourly wage, let’s say at Ford Motor Co. (F), then you report that amount as an expense that reduces profits.

But if you hire workers at, say, Roku Inc. (ROKU) and pay them in stock or options, it’s not an expense that reduces profits. It’s just adjusted earnings.

In fourth quarter 2019, the streaming company Roku reported a net loss of -$15.7 million. But subtract $6.5 million in depreciation and amortization (trick No. 1) and $26 million in stock-based compensation costs (trick No. 2), and perform a little more financial wizardry, and presto, Roku recorded adjusted earnings of +$15.1 million.

In my book, the cleanest and best measure of the true profit-earning power of a business is cash flow.

Cash flow is superior to EPS because it measures the actual movement of money into or out of a business. It’s everything the company earns from selling stuff, minus the cost of the stuff and all operating expenses it takes to produce and sell the stuff. This includes compensation of any kind.

And you can go one better with an even more conservative measure: free cash flow (FCF). This is simply operating cash flow minus capital expenditures (capex), the money used to buy and maintain physical assets such as property and equipment.

Both these figures are easy to find on a company’s quarterly financial statements, or better yet, you can quickly look them up on TradeSmith Finance. Simply search for any stock, click on the Financials tab, and select “Cash Flow Statements” from the dropdown menu to view the most recent figures.

Beware adjusted earnings and focus on a company’s real bottom line. If only it were so easy to “adjust” my brokerage statement to turn stock losses into gains this year!