Investors worried about lofty stock-market valuations may take comfort in signs that companies in the benchmark S&P 500 index are padding their bottom lines less than they have in previous years.
Difference to shrink
Recent changes to accounting standards and a crackdown last year by the Securities Exchange Commission are encouraging many companies to be more cautious about reporting metrics that do not adhere to Generally Accepted Accounting Principles (GAAP). The difference between S&P 500 companies’ GAAP net incomes and the adjusted versions of net income that they play up to Wall Street is expected to significantly shrink in 2017 for a second year, after hitting a high in 2015, according to a Thomson Reuters analysis.
Such a decline may be good news for investors worried that stock prices have risen too far. “The closer reported earnings are to GAAP, the more confident I’d be that investors are getting a fair characterisation,” said Jack Ablin, chief investment officer at BMO Private Bank. On their income statements, companies often exclude “extraordinary” items, like charges associated with layoffs that they believe give investors an unclear picture of their performance. Those adjustments tend to make their profits appear stronger. After an 8% rise in 2017, the S&P 500 is trading at 17.8 times expected earnings, a level many investors consider expensive and increases the risk of a market sell-off. But the expected earnings in that valuation are adjusted, not GAAP.
To the extent that companies use non-GAAP accounting less this year than in recent years, investors may feel more comfortable paying higher valuations for their stocks. “You’re getting more conservative in your earnings approach rather than more aggressive,” said Phil Blancato, head of Ladenburg Thalmann Asset Management. “That’s exactly why I don’t think current PEs are very expensive.”
Following new accounting standards covering the taxation of stock-based compensation, Alphabet Inc. stopped excluding stock-based compensation from its costs in the first quarter. Facebook Inc. said it would no longer emphasise non-GAAP expenses, income, tax rate or earnings per share. Responding to a new standard on revenue recognition, Microsoft Corp. said it will switch to GAAP revenue reporting.
