Monday, July 6, 2009

Earnings, the S&P 500, Analysts and their Wacky Ways.

So over the last few days I have had a few arguments with folks on various message boards about what the fair value of the S&P 500 is. Some say 450, others say 700, still others say it's worth a negative amount.

It's pretty tough to pinpoint and if you wanted to make a really really accurate valuation you'd have to methodically go through each company listed on the index and dissect their books and add the weighted values together to find your perfect number. Plus or minus market sentiment of course ;)

Then you can use the broad valuation numbers like Price to Book and Price to Earnings. But even there you might come across a little snag. If you are talking about earnings, typically the most paid-attention-to number of all the financials of any corporation, most investors go by forecasts.

There are some good forecasters out there and there are some really bad forecasters out there. Typically I have found that the bigger the analyst or firm, the later they are to the party, and the more they follow the same school of thought as the great percentage of the market participants (dumb money) and the guys that read the teleprompter on the tv.

A few people have messaged me about earnings and asked a question about "bottom up" verus "top down" forecasting, as well as "reported earnings" and "operating earnings". Here are the differences (very basically) between these things.


Your typical top-down analyst is a macro-economics type of guy. Top down is a look at the big picture that this particular company is a part of. Top down analysts that are good usually are better at picking earnings in high-growth sectors and emerging business models because they look for new trends influenced by other factors.

Looking at things like demographics, broad social lending and credit or savings, broad investment allocation, broad-based demand for a new product or service, etc etc, are all things that a Top-Down analyst will take into context.

Once he has see the "big picture", he applies that situation to this particular company. By doing so he can venture a guess (which is, after all what analysts do - albeit it's supposed to be an educated one..... sometimes I wonder...) as to how much money this business will make, what their assets will be worth (i.e. are they in higher demand across the market or sector), and their future growth levels.


A bottom-up analyst is usually a by-the-numbers look. It is generally very specific to the company being studied, maybe including some competition or closely related industry players. Bottom-up is more backward looking analysis as it takes previous sets of numbers and applies a growth pattern to them in order to formulate the new estimates for the future.

Good bottom up analysts are usually pretty dead on when dealing with steady-growth companies and blue-chips. They often undershoot earnings in high-growth industries and in the mist of large social trend changes.

Bottom up analysis is a better system of comparison for value-investors while top-down analyst projections are more growth-investor oriented.

Earnings Themselves

So the million dollar questions. Sometimes the multi-million dollar question, actually. What is the difference between "Reported Earnings" and "Operating Earnings"

Reported Earnings

Reported Earnings is the number used in Earnings Per Share, Net Earnings, etc. This is the number used in P/E ratios. Reported earnings adds in any accounting changes that have been made that affect assets - for example the banks took massive writedowns (marked down the value of their loan to more realistic - if still far to high, in my humble opinion) which caused their reported earnings to be negative. If you lose a Billion $ of value in the first quarter, even though you actually made a profit through business activity, that $ Billion loss of value still gets bundled in to reported earnings.

Operating Earnings

Operating Earnings is basically a straight look at how much money the business made by doing it's day-to-day thing. It does NOT take into account any accounting adjustment that have been made and is the number usually posted before Net Earnings or Reported Earnings on an income statement.

It looks kind of like this:

Operating Earnings $1,000,000
plus or (minus) adjustments (474,000)
Net Earnings $526,000

So Operating earnings would be $1,000,000 and Reported Earnings would be $526,000

Hope this clears that up for those with questions. Happy investing all!

I wonder what this week will bring......

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