By David Trainer , Kyle Guske II and Sam McBride
On Jan. 11, we showed that the “earnings recovery” is an illusion . After third-quarter earnings reports, we can say that earnings growth continues to be an accounting mirage. U.S. equities may have rebounded from 2015 lows, but economic earnings — which reverse accounting distortions and account for the weighted average cost of capital ( WACC ) — remain in a persistent downturn. Figure 1 shows this trend.
This disconnect between accounting earnings and economic earnings is not just due to a handful of companies. When we look at our entire coverage universe of over 2,700 stocks, six out of 11 sectors have misleading earnings (GAAP rising and economic earnings falling) in the last fiscal year. Over the last 12 months, six sectors have negative economic earnings, and just two sectors — technology and health care — have positive and rising economic earnings.
The breadth of this decline in economic earnings suggests that the majority of U.S. public companies are unable to earn a return on invested capital ( ROIC ) greater than their WACC on new investments. In other words, the majority of U.S. companies are struggling to find profitable ways to allocate capital.
As Figure 2 shows, the tech sector is one of only two sectors with rising and positive economic earnings. But, the economic earnings picture is not as rosy as GAAP earnings would suggest. While GAAP net income has risen 9% over the past five years, economic earnings are only up 7%. Tech companies also have the most excess cash of any sector, at $1.1 trillion, a sign that they are also struggling to find profitable growth opportunities.
Sources: New Constructs and company filings.
Figure 2 explains why tech has “taken over the market.” It’s been the only option for investors that want real earnings growth.
For example, Microsoft /zigman2/quotes/207732364/composite MSFT -0.15% has more than tripled the return on the S&P 500 /zigman2/quotes/210599714/realtime SPX -0.11% over the past five years. Its economic earnings have grown by 32% compounded annually since 2016 compared to a flatlining net income.
However, many investors are quick to buy into the illusory earnings growth in the rest of the market, which we see as a result of the meteoric increase in the number of noise traders .
The disconnect between accounting and economic earnings in the market stems from two primary issues:
1. Income statement manipulation: Managers exploit accounting loopholes to overstate accounting profits. GAAP net income has grown 6% over the past five years for the companies in Figure 1, but net operating profit after tax ( NOPAT ) is up only 4% over that time frame.
2. GAAP earnings overlook balance sheets and the cost of equity capital . Over the past five years, the companies in Figure 1 have increased their balance sheets, i.e. invested capital , by 32%. Their weighted average cost of capital (WACC) is up from 5.7% to 6.9% over the same time. Economic earnings decline when the cost and amount of capital rise faster than NOPAT.
Economic earnings equal NOPAT - (WACC*Invested Capital). When NOPAT grows slower than net income while invested capital and WACC grow faster, economic earnings decline. Figure 3 details the adjustments we make to calculate the current NOPAT and invested capital values for the whole market.
Our biggest adjustment on the NOPAT side is to strip out nonoperating items that are reported directly in the financial statements, such as interest expense, preferred dividends, and minority interest income. Our Robo-Analyst also uncovered a net $5 billion in nonoperating expenses hidden in the footnotes .
On the balance sheet side, we added back $2.4 billion in accumulated asset write-downs that companies tried to scrub off their balance sheet. Adding back accumulated write-downs holds companies accountable for all the capital invested in the business over its life.
Only by making these adjustments can you reverse accounting distortions and reveal true profitability .
GAAP earnings show a large rebound after the commodities rout caused significant write-downs in 2015. Economic earnings show that this sector still has a long road ahead to recovery. Over the trailing 12 months, DowDuPont Inc. has the largest discrepancy between reported net income and economic earnings. GAAP net income of $2.1 billion vastly overstates the firm’s profitability while economic earnings, at -$5.4 billion, reveal significant losses.
Sources: New Constructs and company filings.
Part of the significant gap between GAAP net income and economic earnings for the consumer cyclicals sector can be explained by off-balance sheet operating leases that constitute a hidden ( although not for long ) form of invested capital. Operating leases account for 9% of all invested capital in the sector, compared to just 5% for the whole market.