The Case For Core Earnings

June 30, 2002

White papers by David Blitzer:


The markets and market participants are living through the aftermath of the bull market of the 1990s. It is proving to be more drawn out, deeper and more threatening than the emptiness felt after the 1987 market crash wiped out more than a fifth of the U.S. equity value in a single day. We are discovering that the bull market extended far beyond largecap technology stocks. It included creative accounting, swapped revenues that didn't really exist, new and opaque forms of financial analysis and, occasionally, fraud. John Kenneth Galbraith,speaking about an earlier era, remarked that depressions catch what the auditors missed. In this bear market - bear markets do follow bull markets just as what goes up must come down - the largest loss is not stock valuations; it is investors' confidence and trust.

Losing confidence and trust is a problem for all of us. The role of financial markets in the economy is to allocate capital and transfer risk. Without trust and confidence, the financial markets won't function and the economy won't grow or prosper. To be sure, confidence and trust are only necessary, not sufficient, conditions for financial markets and economies to succeed. But without renewed confidence and trust, the bear market may deepen and the economy may shrink. As one looks around in the first half of 2002, investors' confidence and trust are being severely tested by reports of bankruptcies, charges of fraud, investigations of accounting legerdemain and occasional collapses of former blue-chip stocks.

The Case For Core Earnings
The case for core earnings is simply this: We need to return accounting and financial reporting to something that investors trust to present a full, fair and understandable picture of corporate results. If, at the end of 2002, investors can look back at a third consecutive down year in the U.S. markets,something not seen since 1941, and if they see no progress towards reforms to prevent the abuses of recent years, they will take their money someplace else - banks accounts, foreign stocks or gold to bury in the back yard. A wholesale exit from the equity markets would be damaging to the U.S. markets, the U.S. economy and the dollar - and to everyone in the markets.

Standard & Poor's did not start its core earnings project because it believed it could force anyone to use its analysis or because it has a monopoly on how to do accounting. Standard & Poor's cannot force anyone to follow its lead, nor does it have any monopoly on accounting. However, the company is fortunate to not have the potential conflicts of interest that investment banks may suffer. Further, with the wide recognition of the S&P 500 and the wide use of the S&P's Compustat data base, Standard & Poor's is in a position to encourage people to notice the importance of better earnings measures.

Core Earnings
The idea behind core earnings is to include all the expenses and all the revenues that are part of a company's core or main business, and to exclude anything that is not part of the core business. An analyst studying and forecasting a company's longterm prospects will focus on its main business rather than corporate accounting adjustments or changes. An investor considering a stock is interested in the stock's main business and how it is likely to fare over time. When company management is managing the business for consistent longterm growth, it is also interested in the prospects of its core business. Things like litigation, hedging activities, and sales of other assets may matter quarter to quarter, but are less important and more difficult to forecast if the goal is understanding the company's economic prospects.

One commentator noted that the idea of an investor or a manager wanting to know the revenues, expenses and profits or losses of the core business is rather old-fashioned. It is, but as another commentator remarked, the truth is usually old-fashioned, which is why it sometimes goes out of fashion during bull markets.

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