misLeading Indicators: How to reliably measure your business

Core earnings don’t get to the heart of profitability

Posted on | November 20, 2012 | 1 Comment

A couple of weeks ago Manulife Financial, a large Canadian insurance company, introduced a new metric called “core earnings.” They reported a net loss of $227 million in the third quarter, but $556 million in core earnings.

The problem with core earnings as an indicator is that it attempts to determine the revenue from the main or principal business, as opposed to the supposedly ‘minor’ or ‘secondary’ business of exceptional items.  The goal is to get rid of the ambiguity caused by earnings statements that report or exclude “exceptional,” or “special” items.  But these items are all too frequent.

Manulife is joining many other firms reporting core earnings. The company’s report said:

“In the third quarter of 2012, we are introducing core earnings, a new metric, to help investors better understand our long-term earnings capacity and enterprise value. Core earnings measure the underlying profitability of the business and remove mark-to-market accounting driven volatility as well as a number of items that are material and exceptional in nature. While this metric is relevant to how we manage our business and offers a consistent methodology, it is not insulated from macro-economic factors which can have a significant impact. In the third quarter of 2012, Manulife generated $556 million of core earnings.”

Exceptional items have a disturbing habit of not being so exceptional. Benjamin Graham, in his classic book The Intelligent Investor, described the case of Alcoa back in 1968. The company had a number of special charges in their annual report, including the building of a wall. Graham says “the alert investor might ask himself how does it happen that there was a virtual epidemic of such special charge-offs appearing after the close of the 1970s, but not in previous years? In some case they might be availed of to make subsequent earnings appear nearly twice as large as in reality.”

What defines a special item? In a large corporation there are many special events occurring in any given year. They are part of the ordinary episodic life of business in tumultuous markets. As the Roman poet Ovid said, “Nothing continues the same for long.” Perhaps many business people believe they know what the True State of Their Business Affairs should look like, and any event that is not part of the True State should be cleansed so you can see how much money the business was supposed to make.

Accounting rules state that extraordinary items are supposed to be both unusual and infrequent. But they are now so frequently reported that accounting professors conduct large statistical studies of them. One study analyzed 63,875 firm-years (one company for one year) between 1988 and 2002 and found that, on average, 19 percent reported special items, ranging from a high of 51 percent in low-accrual firms to 12 percent in high-accrual firms. They concluded that “special items reflect underlying economics and are indicative of firms that have over-invested in strategies that have not worked.”

If 19 percent of firms in a typical year report special items, which reflect underlying economics and strategies that have not worked, they are not very special. The September 11 attacks were extraordinary events, certainly unusual and hopefully infrequent, in the minds of most of us, yet the US Financial Accounting Standards Board did not allow companies to treat losses they incurred from these attacks as special items.

Earnings are, strictly speaking, not a measurement at all. A measurement has a clear standard to measure against. There is tremendous discretion in determining earnings. When reporting earnings there is leeway, for example, in determining when to book revenue, choosing a depreciation rate, deciding how to treat inventory and inventory write-downs, and reporting pension fund growth. It is thus more of a characterization than a measurement.

There is much less discretion in cash flow as an indicator (see these posts by MarketBeaters here and here), although there is still some leeway in determining it.  Consistent positive cash flow, may be, for this reason, a good indicator of the wealth-generating ability of a company. If a company does not generate positive cash flow it could go belly up even though it has (positive) earnings.

The usefulness of core earnings as an indicator of profitability will only be proven with the test of time.

Philip Green and George Gabor are co-authors of misLeading Indicators: How to Reliably Measure Your Business, published by Praeger. www.misleadingindicators.com

© 2012 Greenbridge Management Inc.

 

Comments

One Response to “Core earnings don’t get to the heart of profitability”

  1. Core earnings: Is new metric misleading? : misLeading Indicators: How to reliably measure your business
    December 3rd, 2012 @ 9:33 am

    [...] Core earnings don’t get to the heart of profitability [...]

Leave a Reply







  • Buy Your Copy

    On sale Feb 29, 2012

    Price $48

    Buy from Barnes and Noble

    (In stock now).

    Buy from Praeger (Publisher).

    (In stock now)

    Order ebooks 1-800-368-6868 (7am to 430pm PST, Mon-Fri) or 805-968-1911 ext 312

    Order by email


    Buy Amazon US

    Buy from Amazon.com
    In stock.

    Buy Amazon Canada

    Buy from Amazon.ca
    In stock

    Read the first two chapters: Click here.

  • Tag Cloud

    background information cancer census coin flip credit rating customer complaints customer service dashboard debt economic activity exception reporting fashion industry fraud gas pump GDP gold happiness hurricane investing in measurement jobs key performance indicator Lance Armstrong leading indicator medical studies mineral resources Obama on-line p-value polls productivity public health quality of life radar randomization Romney safety science six sigma statistical process control stimulus stock market unemployment unmeasurable US Election wealth
  • Archives