Skeptics say stocks are wildly overvalued. Optimists say stocks are attractive relative to Treasuries. Can they both be right?

They can, as long as Wall Street can't agree on how to best measure corporate earnings.

Setting aside the debate as to whether past or projected earnings matter most, the issue at hand is that investors can't even agree on the best way to account for the past. Depending on whether investors use the relatively lenient operating earnings that still prevail in many corners of Wall Street, or results based on the generally accepted accounting principles (GAAP) required in SEC filings, or Standard & Poor's recently unveiled "core earnings," they are reaching vastly different conclusions about the appeal of stocks at current prices.

For example, the companies comprising the

S&P 500

posted operating earnings totaling $44.93 a share for the 12 months ended June 2002, according to Thomson Financial/First Call. (Final third-quarter results have not yet been tallied). First Call publishes "operating" or "pro forma" earnings, which exclude extraordinary items as defined by the Financial Accounting Standards Board (FASB). The exclusions include most restructuring charges, goodwill impairment, inventory writedowns, asset sale gains, merger-related expenses, etc.

Based on Wednesday's close of 914.15, those operating earnings resulted in a trailing price-to-earnings ratio of just over 20 for the S&P 500, which seems pretty reasonable given Treasury yields. Using the so-called

Fed

model, which compares the earnings yield (or earnings divided by price) of the S&P 500 to the yield of the benchmark 10-year Treasury (just above 4%), stocks are about 30% undervalued based on operating results, bulls contend.

However, widespread abuses of write-offs and other "one-time charges" in the 1990s have led many observers to focus on net income based on GAAP. This measure doesn't allow the exclusion of most "extraordinary items." On this basis, S&P 500 earnings were just $26.76 a share for the 12 months ended June 30, resulting in a trailing P/E of 34.2 and negating the "for sale" sign hanging on equities.

Diane Garnick, global equity strategist at State Street in Boston, which manages more than $700 billion, said she and other quantitative strategists prefer the GAAP guidelines to ensure uniformity of results. "There are so many different ways to calculate operating earnings, you lose the ability to compare" one company to another, Garnick said.

To demonstrate the fallibility of operating results (and the level of abuse in the bubble era), she noted that the spread between operating results and GAAP earnings has been steadily widening in recent years and that 28% of S&P 500 companies restated results in the two years ended Nov. 15. That's the largest period of restatements since 1991, when FASB introduced pension-fund accounting.

Many observers agree GAAP earnings are a fairer representation of corporations' profitability, but operating earnings are still widely used by many market participants and vendors, such as First Call and Multex.

"Our goal is to have earnings on the basis that the majority of the investment community would want,

and numbers on an operating basis are closer to what the overall majority wants," said Chuck Hill, director of research at First Call, which has recently added GAAP earnings to its offerings.

Despite the abuses of the 1990s, Hill argued operating earnings are preferable to other methods, provided companies "leave a trail from GAAP to pro forma." Specifically, they should provide clear information on what items are being excluded and what amount, and why they're justified as extraordinary items.

Jeffrey Kleintop, chief investment strategist at PNC Advisors in Philadelphia, largely agreed with that assessment. Operating earnings "are the best thing we have," said Kleintop, whose company manages more than $55 billion in assets.

Operating earnings were overstated in the late 1990s, Kleintop acknowledged. But in the wake of scandals, bankruptcies and arrests, company directors, auditors and management are now "energized" to be "cleaner than in the past," he argued.

Furthermore, "except for a blip in 1998-1999," operating earnings have closely tracked the corporate profits posted by the Bureau of Economic Analysis' national income and product account, the strategist observed. "Operating earnings make sense, and I think on that basis stocks are relatively attractive," said Kleintop.

Then again, the strategist's embrace of operating results fits with his bullish outlook, having adopted an overweight rating on stocks in September.

For participants at the opposite end of the spectrum, there are so-called

core earnings, as defined by Standard & Poor's.

Core earnings are an even stricter interpretation of profits than GAAP earnings, as they include almost all one-time items, as well as (most crucially) employee stock options expenses and gains or losses from pension-fund investments. Core earnings for the S&P 500 were just $18.48 a share for the year ended June 30, resulting in a trailing P/E of 49.5.

"Put that 50 x P/E in your value pipe and smoke it," quipped Bill Gross, managing director at bond fund giant Pimco, which has over $300 billion under management. "The late 1990s bubble valuation has yet to be corrected," Gross wrote at the firm's Web site earlier this month. "Unless true earnings accelerate sharply, stock investors are seeing

and buying a lot of white elephants these days."

Gross is extremely bearish on stocks, having recently argued that the Dow will fall to 5000 and that the S&P 500 is fairly valued at 650, nearly 30% below current levels.

The big difference between S&P's core earnings and other measures is due mainly to heavy pension-fund liabilities for many industrial firms. According to S&P,

General Motors

(GM) - Get Report

would have posted a loss of $4.21 a share for the year ended June 30 compared with GAAP earnings of $3.21, while

DuPont

(DD) - Get Report

would have suffered a loss of 27 cents a share vs. GAAP earnings of $4.96.

Meanwhile, employee stock options account for the big difference in reported and core earnings at many tech companies. For example,

Cisco

(CSCO) - Get Report

would have posted core earnings of 13 cents a share for the year ended June 30 vs. reported earnings of 25 cents. Similarly,

Adobe Systems

(ADBE) - Get Report

would have suffered a loss of a penny per share vs. a reported profit of 76 cents.

To date, 66 S&P 500 components have declared they will expense options in fiscal 2003, according to S&P. However, the firm's core earnings guidelines are a long way from being adopted as corporate America's standard.

"It would be commercially wonderful

if that were the case, but we'd be fooling ourselves" to claim as much, said David Blitzer, managing director at S&P.

World of Confusion

Critics of S&P's core approach say the methodology is flawed because there are no historic core earnings with which to compare current levels. Another argument is that trailing results are irrelevant and it's hard to generate solid core earnings forecasts because predicting future option expenses and the performance of company pension funds is so difficult.

Jeffrey Saut, chief strategist at Raymond James, disputed the latter argument, wondering if "anyone can give decent forward estimates" based on any definition. Still, he suggested that S&P's core earnings initiative has, thus far, mainly complicated an already murky environment, contributing to his views that stock proxies will be range-bound for the foreseeable future.

"All

core earnings do is bolster my case that there's so much confusion out there that even if earnings come back strong the market isn't going to capitalize them at anywhere near the same multiple," as in the late 1990s, he said. "There are 10 or 12 different ways to report earnings, and some guys still don't get it."

The lack of agreement on earnings standard has many market participants using their own calculations of profits.

Robyn Brenza, a spokeswoman for T. Rowe Price with over $130 billion under management, said managers at the Baltimore-based firm "have built their own models for the companies they follow and are most comfortable using them."

Susan E. Ulick, director of equity research for TIAA-CREF, which managed $275 billion at the end of 2001, said its analysts aren't using S&P's core guidelines, but are "focusing much more time on critical variables,

such as taking a look at whether there's phenomena in earnings that aren't really earnings and asking should we back them out."

Indeed, even if money managers don't formally adopt S&P's definition of core earnings, its new calculations have helped investors focus on "important stuff" that is being excluded from most earnings calculations, Blitzer said. "On that there's agreement."

Investors may argue over whether or not employee stock options should be expensed, or at what level. But most people agree options and pension-fund liabilities should not be totally excluded from a firm's earnings, he said. "None of us did our homework for a few years. This is the homework," figuring out a company's true earnings when all expenses (and gains) are included.