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Kiplinger's Personal Finance: The two sides of corporate profits
Kiplinger’s Personal Finance

Kiplinger's Personal Finance: The two sides of corporate profits

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An analysis of corporate profits isn’t as straightforward as it would appear from the business-news headlines.

Stock investors of all stripes care about corporate earnings. Lately the earnings picture for the broad stock market has been cloudier than ever, frustrating professional and armchair analysts alike.

Where earnings are headed in the second half of 2020 is still difficult to figure out given the uncertainty surrounding the reopening of the economy, said Jeff Buchbinder, a market strategist at investment research firm LPL Financial.

“Until we get a vaccine, or dramatic leaps forward in treatments that make people comfortable resuming some semblance of normal life, earnings will have an extremely difficult time returning to pre-pandemic levels,” he said.

Investors should be aware that even in normal years, an analysis of corporate profits — the main driver of stock market returns over time — isn’t as straightforward as it would appear from the business news headlines.

In fact, there are frequently two versions of earnings for any given company in any given quarter. If you are assessing an individual stock, it’s important to be clear about which version you’re looking at, and why.

It might surprise you to learn that the accounting of corporate profits required by law in every publicly traded company’s earnings statement is frequently not the version touted in the news.

The “official” statement must include GAAP earnings — those that adhere to generally accepted accounting principles. GAAP rules aim to standardize accounting practices for all U.S. firms so investors can make apples to apples comparisons.

But because GAAP standards require companies to bake certain expenses into their earnings numbers — costs that execs say don’t reflect a firm’s true operating performance — most companies report non-GAAP earnings as well.

Often listed as “adjusted” or “core” earnings, these numbers strip out one-time, non-recurring charges such as costs associated with acquisitions, litigation or corporate restructuring. This version is likely the one you’ll see heading up earnings press releases and in stock write-ups by analysts.

In the wake of the COVID-19 pandemic, which has given a shock to many firms’ operations, non-GAAP measures can be helpful for understanding what’s going on in the business, Morningstar global data director for equity research Adrien Cloutier said. “But you have to watch your step. These adjustments are made at management’s discretion. It’s not the least biased view,” he said.

A big discrepancy between GAAP and non-GAAP earnings on its own doesn’t mean that executives are misleading shareholders, but it could be a sign that you’re comparing apples to oranges if peer firms are not making similar adjustments.

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