How to find the core earnings of a company

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I worked in equity research for 12 years. That’s a long time. It was fun at times, but not always. There is a kind of grind to the job, and it is getting harder and harder to stand out. But I am glad I did it and learnt about a bunch of industries. I also talked to really smart people and had to really debate and defend my ideas.

One of the things that I got really good at was looking at financial statements. One of the first things that you find, and this changed over my career, is that there are GAAP earnings (those required by the accountants) and then there was “real” earnings. As an analyst, I would take the numbers, put them in excel. Then when I was forecasting future earnings, I would strip out anything that wasn’t recurring to get a better sense of the real earnings potential, based on what the company had done before. A video game company’s net income was boosted by selling a building? That’s a one-time deal. The government pays back a real estate company for some infrastructure works, and the company books it as revenue? Unlikely to persist. I would strip these things out to make sure I understood what the core earnings were.

Every analyst does/did this. In fact, it’s probably something that most analysts would say is a strong suit of theirs

So I was surprised to see that actually, analysts are not that great at stripping out non-recurring items.

This paper makes the case that analysts miss a lot of non-recurring items. But if you go deep into the financial statements, you can actually find core earnings that are different from those that the analyst report. The conclusions from this are:

  • Core earnings are better at predicting future earnings/cash flows than GAAP earnings. But they are also better than analysts’ numbers, also known as Street consensus earnings. Street consensus earnings take an average of all of the analysts’ earnings. While, Street numbers are better at predicting future cash flows than GAAP earnings, but not as good as using “core earnings.”

  • Finding “true” core earnings is even more important than it was historically, because the number of adjustments has increased over the past 20 years. It was 4 in 1998 and rose to 8 by 2017. It’s not only the number: the amount of the adjustments has increased and is significant - around 15% of GAAP earnings per share in 2017.

  • You can use this data to make money, because the market is slow to incorporate this information on non-core earnings.

Why can’t we just use Street consensus? It turns out that analysts (like me) do make adjustments. Unfortunately, they make similar ones as managers. They are too willing to take management on faith.

Did I ever do this? I plead the 5th! No, actually, I tried to come up with my own views, but sometimes I probably went with what management said. Also, remember, analysts have calls on stocks. If information goes against their call, they may be hesitant to air it. I tried not to do this, but I am sure occasionally I presented my “buys” more positively than my “sells.”

So just to help equity analysts out there, the key non-core items to look at should be:

  • Expenses related to acquisitions

  • Currency revaluations/devaluations

  • Discontinued operations

  • Legal or regulatory events

  • Pension adjustments

  • Restructuring

  • Gains and losses that are disclosed as “other”

Take all of these out to get to core earnings. And you can’t just use the financial statements and notes. It turns out that about 50% of the non-core items are hidden in the MD&A - Management Discussion and Analysis. So you gotta really get into the financials.

Here’s a business idea: start doing this for emerging markets as well. I bet there is a lot to be gained by it. You might want to talk to New Constructs first, though. They seem to have gotten this down to a science.

(H/t Matt Levine for writing about the paper)