In a recent presentation, available here, we included a slide displaying the gap between actual and trend earnings per share. We concluded that if you believe today’s historically-high earnings can be sustained then US equities look mildly expensive. But if you think that earnings will mean-revert, AS THEY ALWAYS HAVE, then US equities are nose-bleed expensive.
The chart below, from Andrew Smithers at the FT, would suggest that equity investors should keep a box of tissues next to their Bloomberg. According to Smithers, the gap between True Profits & Published Profits is the result of the much greater incentives for management to alternately over-and-understate the “true” profits, and the much greater ability to do so.
The massive rise in bonuses paid to managements, which depend on the data the companies publish, has encouraged companies to boost profits in the short-term as bonuses often depend on short-term changes in earnings per share or return on equity. Even when they are more directly related to changes in share prices, these often respond to similar changes in the published data. Parallel with this rise in incentives to misrepresent profits has been an increasing ability to do so, with the change from “marked to cost” to “marked to market” accounting.