Once Again, Wall Street Is Ripping Off Main Street.
By Stephen Porter
THE LAWSUITS BY Sunbeam shareholders alleging overstatement
of earnings may be a sign of things to come. There is good reason
to believe that the earnings growth reported by many top American
companies in the past few years is largely illusory, more the
product of questionable accounting practices rather than business
success.
As investors wake up to this fact and share prices inevitably
fall to their proper values, many thousands of angry shareholders
and mutual fund owners will be demanding to know why this was
allowed to happen.
The Economist in its April 18 issue, page 69, gives an
example. Stock options issued to management and staff are part
of their compensation package, and this cost to the company is
properly part of wages and salaries expense. However, accounting
for these stock options bypasses the income statement, and this
has "caused profits for 100 of the largest American firms
to be overstated by 42 percent in 1995 and 57 percent in 1996."
Investment guru Warren Buffet says this "accounting practice
of ignoring the cost to a business of issuing options" is
"dead wrong" according to quotes in the May 18 issue
of Forbes magazine. There is an inflation impact. Recognizing
options as employment income would increase the growth of income
by 2.5 percent. Forbes asks the question (page 215) "Would
the market have risen 20.3 percent in 1996 if the 100 biggest
companies had reported earnings gains of only 11 percent? Doubtful."
Forbes goes on to quote an analyst saying that "the
current P/E multiple on the S&P 500 is 35, not the 28 usually
shown." The Price/Earnings multiple is one of the key indicators
investors use to value stocks.
The accounting treatment for options is only one of the tricks
corporations are using to inflate earnings. For example, Forbes
says that Kellogg's has taken "one-time charges" nine
times in the past 11 quarters. "One-time charges" are
another misuse of accounting designed to artificially enhance
earnings because they bypass operating income and expense in the
income statement.
Forbes' March 23 issue discusses at length the various
tricks now being used by corporate management to enhance the value
of their share options by overstating earnings. Other tricks include
reporting acquisitions as mergers so that companies can avoid
reporting "goodwill" (which must be amortized over 40
years, thus reducing earnings for a long time into the future),
and improper reporting of revenues and expenses to bolster the
current quarter. Companies reported to be engaging in these frauds
include General Motors, Boeing, Kellogg's and many others.
Forbes quotes an analyst who suggests that cash flow and
earnings should generally track together, and if earnings leave
cash flow behind then something is wrong. The problem is that
"looking at stock prices versus cash flow for the S&P
500, you get an all-time reported high..." The phenomenon
is widespread.
The use of options to supplement the compensation of management
and employees has become common only in the past few years. There
seems to be good evidence that this practice is leading to deceptive
accounting, artificially inflated earnings, and a bull market
based on widespread fraud and deceit. Main Street America is being
mugged by Wall Street once again. The truth now coming out could
bring disaster to many small investors who have put their retirement
savings into equity mutual funds.
This is perhaps the greatest story of the bull market. The bull
market does not need a rise in interest rates for it to come to
an end, nor a crash in the far east, nor a year 2000 computer
problem. All the bull market needs to bring it to an end is for
a majority of investors to realize they're being lied to, that
corporate earnings are to a large extent non-existent, that American
shareholders are falling victim to the same corrupt accounting
that is criticized in Korea and other developing economies.
The Economist reported options "caused profits for
100 of the largest American firms to be overstated by 42 percent
in 1995 and 57 percent in 1996." What was it in 1997? What
happens to earnings if you remove all the other tricks? When the
market crashes and people lose their savings, their consumption
will go down and the economy will contract. What will earnings
be then?
Given that stocks after a crash will trade at much lower multiples
of earnings, how far down can the market go?
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