Most Popular
1. Banking Crisis is Stocks Bull Market Buying Opportunity - Nadeem_Walayat
2.The Crypto Signal for the Precious Metals Market - P_Radomski_CFA
3. One Possible Outcome to a New World Order - Raymond_Matison
4.Nvidia Blow Off Top - Flying High like the Phoenix too Close to the Sun - Nadeem_Walayat
5. Apple AAPL Stock Trend and Earnings Analysis - Nadeem_Walayat
6.AI, Stocks, and Gold Stocks – Connected After All - P_Radomski_CFA
7.Stock Market CHEAT SHEET - - Nadeem_Walayat
8.US Debt Ceiling Crisis Smoke and Mirrors Circus - Nadeem_Walayat
9.Silver Price May Explode - Avi_Gilburt
10.More US Banks Could Collapse -- A Lot More- EWI
Last 7 days
Stock Market Volatility (VIX) - 25th Mar 24
Stock Market Investor Sentiment - 25th Mar 24
The Federal Reserve Didn't Do Anything But It Had Plenty to Say - 25th Mar 24
Stock Market Breadth - 24th Mar 24
Stock Market Margin Debt Indicator - 24th Mar 24
It’s Easy to Scream Stocks Bubble! - 24th Mar 24
Stocks: What to Make of All This Insider Selling- 24th Mar 24
Money Supply Continues To Fall, Economy Worsens – Investors Don’t Care - 24th Mar 24
Get an Edge in the Crypto Market with Order Flow - 24th Mar 24
US Presidential Election Cycle and Recessions - 18th Mar 24
US Recession Already Happened in 2022! - 18th Mar 24
AI can now remember everything you say - 18th Mar 24
Bitcoin Crypto Mania 2024 - MicroStrategy MSTR Blow off Top! - 14th Mar 24
Bitcoin Gravy Train Trend Forecast 2024 - 11th Mar 24
Gold and the Long-Term Inflation Cycle - 11th Mar 24
Fed’s Next Intertest Rate Move might not align with popular consensus - 11th Mar 24
Two Reasons The Fed Manipulates Interest Rates - 11th Mar 24
US Dollar Trend 2024 - 9th Mar 2024
The Bond Trade and Interest Rates - 9th Mar 2024
Investors Don’t Believe the Gold Rally, Still Prefer General Stocks - 9th Mar 2024
Paper Gold Vs. Real Gold: It's Important to Know the Difference - 9th Mar 2024
Stocks: What This "Record Extreme" Indicator May Be Signaling - 9th Mar 2024
My 3 Favorite Trade Setups - Elliott Wave Course - 9th Mar 2024
Bitcoin Crypto Bubble Mania! - 4th Mar 2024
US Interest Rates - When WIll the Fed Pivot - 1st Mar 2024
S&P Stock Market Real Earnings Yield - 29th Feb 2024
US Unemployment is a Fake Statistic - 29th Feb 2024
U.S. financial market’s “Weimar phase” impact to your fiat and digital assets - 29th Feb 2024
What a Breakdown in Silver Mining Stocks! What an Opportunity! - 29th Feb 2024
Why AI will Soon become SA - Synthetic Intelligence - The Machine Learning Megatrend - 29th Feb 2024
Keep Calm and Carry on Buying Quantum AI Tech Stocks - 19th Feb 24

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

Protect Your Stocks Portfolio Against Wall Street's Greatest Lie

Companies / Corporate Earnings Jul 31, 2012 - 08:53 AM GMT

By: Money_Morning

Companies

Best Financial Markets Analysis ArticleKeith Fitz-Gerald writes:"Can't anybody tell the truth anymore?" an exasperated Bob J. asked me at a recent cocktail reception.

"Evidently not" I told him.

Bob had seen me earlier that afternoon on Fox News. I appeared on the show to respond to a new study on corporate earnings by Professors Ilia Dichev, Shiva Rajgopal of Emory University and John Graham of Duke.


The study found that a full 20% of publicly traded companies lie about their earnings.

The shocking thing is that the figure wasn't much higher. Twenty percent strikes me as abnormally low. Earnings manipulation is one of Wall Street's greatest, best-kept secrets and has been for years.

In fact, CFOs I've met over the years have told me they could routinely swing things within 5-10% of the target earnings per share (EPS) if needed - a figure in line with the one cited in the study.

But lie is a big word.

As I noted during my interview, there are all kinds of reasons why companies manipulate the numbers, beginning with the terribly flawed system itself.

As appalling as this thought may be, the system actually encourages this kind of behavior.

Under the current system, the law requires quarterly performance reports when many publicly traded companies actually operate in business cycles that are 1, 3, 5, or even 7 years long.

This creates a disincentive to report what's actually happening and an incentive to "lie" about the numbers or at least "fudge" them, depending on your perspective. And, the longer the business cycle, the more a company must make estimates about quarterly results with the risk, of course, that things don't turn out as management expects.

So while some companies may have lost their ethical and moral compasses, what they are doing is entirely legal.

Why Companies Lie About Earnings
Having spent more than 20 years in the markets, I believe the reason for this comes down to three biggies, for lack of a better term. Companies may "lie" to boost stock prices, smooth earnings and jack up compensation packages.

Virtually every publicly traded company draws on reserves and engages in all kinds of financial hocus-pocus in an effort smooth things out.

Take Boeing Co. (NYSE: BA), for instance.

The aircraft design, production and sales process is roughly 5-7 years long. For Boeing, quarterly earnings are nearly irrelevant.

Investors would be better served if the company issued annual or even bi-annual data that better matched Boeing's cash flows and product development cycles.

At the other end of the spectrum is Facebook (Nasdaq: FB).

Team Hoodie brings in revenue from a customer base that has the attention span of a New York cab driver focused on his next fare amid a sea of pedestrians. For Facebook, weekly earnings data might be best.

Under these circumstances, there's immense pressure from inside and outside the company to "hit" the numbers, avoid debt covenant violations and influence shareholder, lender, and supplier expectations - all of which are carefully orchestrated to boost share prices over time.

These pressures are so great the gamesmanship uncovered by the study isn't surprising at all.

It's unpleasant. It's unethical. And it's disheartening. But it's not shocking.

How to Spot Earnings Gamesmanship

So how do you know if a company you own is cooking the books, and what do you do about it?

It's not easy, but here are six things to watch for:

1.Cash flow, cash flow, cash flow. Nobody ever went broke on accrual accounting and cash truly is king, especially now. That's why I am especially interested in a company's free cash flow. It's tougher to fake. A quick and dirty method to calculate this is simply to subtract capital expenditures from operating cash flow.
2.Big changes in accruals. These can come in many forms. Examples include capitalized expenditures, reserves, and accrued liabilities. Sometimes there's an explanation, like pending litigation or a product recall, but CFOs don't build these up for no reason.
3.Big one time charges. Lately these are de rigeur and examples include write-downs, write-ups, trading losses, unusual transactions and, my personal favorite since the financial crisis began, gains or losses on asset sales, particularly toxic debt.
4.Unrealistically smooth earnings. Business cycles vary tremendously, so it's logical that earnings should too, perhaps not wildly, but they should show some variability under normal circumstances. Any business that doesn't is immediately suspect in my book because either a) there are hidden accounting games being played or b) the company might really be run well in which case it's worth an even closer look.
5.Wide variations from their peer group. Not all companies are the same so don't expect cookie cutter analysis to work. But if a company is way outside similar figures reported by its peers, chances are something's "up."
6.The people. Admittedly, this is more art than science. It's where you've either got to hone your instincts or study interpersonal behavior. I've actually had formal training on how to spot individuals who may not be entirely honest. So I listen carefully during analyst calls for voice tremors and watch televised interviews much more closely for physical tells than other people might. You may not be in the same boat, so I encourage you to use what I call the bar test...as in would you turn your back to this executive/politician/leader during a bar fight? If not, have faith in your instincts because chances are you don't want to trust the person you're observing.
I'll leave you with one final thought.

Under the circumstances, this kind of information may shake your confidence in the system. I know it does mine. But there's little we can actually do about it until the regulators, Wall Street, and Congress stop the incestuous relationships they maintain and force a return to more cash-oriented reporting standards.

So concentrate your investments in companies that have long histories of doing the right thing and management that has repeatedly demonstrated integrity.

Focus on companies with strong international cash flow and brands the world needs. Wants are secondary during difficult times like today. Needs are constant.

Finally, place a priority on dividend payers. People forget that dividends are not just about yield. Instead, dividends are an implied promise management has made to you as an investor.

Companies that keep their promises are far less likely to screw around with your returns.

Source :http://moneymorning.com/2012/07/31/how-to-protect-your-portfolio-against-one-of-wall-streets-greatest-best-kept-secrets/

Money Morning/The Money Map Report

©2012 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email: customerservice@moneymorning.com

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investent advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Money Morning Archive

© 2005-2022 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in