Reported Earnings and Other Half-Truths

Despite all the attention that accounting scandals have gotten in recent years, many companies still report earnings that overstate the strength of their business. You can be fooled badly -- even by rule-abiding companies -- and lose money in the market if you rely on reported earnings per share alone.

The reason is that standard accounting rules do a poor job of identifying what ultimately moves stocks: how much real value a company is creating on behalf of shareholders.

For one thing, earnings can be overstated by practices such as taking money out of reserves set aside to cover bad debts, or booking paper profits on pension investments.

Another problem is that reported earnings often understate the cost of the money that companies invest in their businesses.

Managers, for example, regularly use "retained earnings" to fund new projects. There's nothing inherently wrong with this, but the problem for outside observers is that they never really book a "cost" for that money -- the equivalent of how much interest they would have paid to borrow the dough in the real world. So managers may reap lousy returns on retained earnings but still report respectable earnings growth, giving the impression they are doing a good job.

One way to cut through the noise is to borrow a tool from the consulting world known as economic value added, or EVA. The system weeds out accounting gimmicks to get at true profit levels. Part of this involves calculating a company's real cost of capital -- including a fair-market interest charge on retained earnings that are plowed back into the business. Size up real profits against the true cost of capital and you get a better sense of how much economic value managers are creating for shareholders.

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At the time of publication, Brush held none of the stocks mentioned, although positions may change at any time.

Brush is an award-winning New York-based financial writer. In addition to writing for RealMoney, he has a weekly market column on MSN Money called Company Focus, and a column called Insiders Corner at InvestorIdeas.com. Brush has covered business and investing for The New York Times, Money magazine and the Economist Group. He studied at Columbia Business School in the Knight-Bagehot Fellowship program and the Johns Hopkins School of Advanced International Studies. He is the author of Lessons From the Front Line, a book that offers insights on investing and the markets based on the experiences of professional money managers.

Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Brush appreciates your feedback; click here to send him an email.