What's the difference between reported and operational earnings

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Q: What's the difference between reported and operational earnings and is there a standard reportable format? In Dick's column he suggested that stocks are becoming of value at some point. On about the same day the Wall Street Journal reported that the P/E ratio of the S&P 500 was about 24 i.e. high and that the Q ratio is also flashing an overvalued market.

A: Today's Wall Street Journal shows the P/E ratio for the S&P 500 at 21.0. That is based on as-reported earnings from Birinyi Associates, Inc. Basically, one can think of as-reported earnings as the "all in" earnings. It will include the cost of non-recurring items (eg. cost of shutting down a factory); therefore, earnings will be depressed relative to operating earnings, which exclude non-recurring items and also don't include profits earned from investments or interest and taxes.

Operating earnings boil down to the subtraction of operating expenses from operating revenue and are considered by analysts to be a better gauge of trends in a company's core business.

Some investors will look at as-reported earnings and others will look at operating earnings. For what it's worth, Warren Buffett said in his recent letter to shareholders, "Operating earnings, despite having some shortcomings, are in general a reasonable guide as to how our businesses are doing. Ignore our net income figure, however."

The P/E ratio of 13 I cited in yesterday's Page One was computed by taking the price of the S&P 500 and dividing it by the forward four quarter consensus earnings estimate of $98.29, which is the consensus estimate tabulated by Thomson Reuters in its survey of analysts who provided operating earnings estimates.

We think a better way of gauging value for the stock market is taking the inverse of the P/E ratio, which is referred to as its earnings yield. The current earnings yield is 7.58% versus the 10-year Treasury note (our risk-free rate) of 3.35%. The difference is the risk premium, which is typically higher for stocks since they are not risk-free. Still, a 423 basis point spread is well above levels that were closer to 200 basis points on average during the 2003-2007 bull market. The high risk premium reflects a heightened degree of uncertainty about the earnings outlook that we feel will dissipate as geopolitical happenings die down and economic data continue to show growth in the U.S. economy being led by a pickup in hiring activity.

I hope this helps with respect to getting a sense of why we still think there is value in the stock market.

Patrick J. O'Hare
Chief Market Analyst

MARKET PLACE