How Companies Fool Investors with Profits Fad

Companies may be worth less than investors think, writes columnist Jason Zweig in a recent Wall Street Journal article.

Zweig explains that investors look to earnings-per-share to assess corporate profits and that, over the past twenty years, companies have devised “newfangled” measures of such as Ebitda—earnings before interest and taxes, depreciation and amortization. He argues that this modified measure of cash flow can be misleading. “This charade,” says Zweig, “is meant to flatter profit by removing costs from reported earnings.”

Citing other versions of “modified” earnings metrics, Zweig notes that the long bull market has enabled companies to come up with more and more earnings “mutations,” which they are also using as a basis for awarding bonuses and other incentive payments to managers. “When managers’ pay is based on a ‘costs-don’t-count’ metric,” writes Zweig, “that sort of thinking may pervade other decisions as well.”

Since such new metrics are not governed by official accounting rules, the article explains, they are not subject to audit. According to Zweig, “Artificially rising stock prices mean artificially rising pay packages for managers who cook up such measures.” He concludes, “If professional portfolio managers want to win back the hearts and minds of investors, they should stop participating in the farce of fanciful earnings—before it does serious damage to the market.”