With so much investor skepticism over pro forma earnings this year, Merrill Lynch ( MER) has decided to change the way it analyzes financial results.

The move comes two months after Merrill and the New York State Attorney General Eliot Spitzer settled a 10-month long investigation into the firm's research practices. Merrill has come under heavy criticism for publicly touting certain Internet stocks while privately disparaging them. But it has also reaped scorn for failing to detect and report various accounting schemes at companies like Enron and WorldCom.

From now on, the brokerage said its analysts would focus not only on how much a company earns, but also on the underlying quality of those earnings.

Numbers Are Not Reality

Merrill defines high-quality earnings as those that are close to being realized in cash, repeatable and the product of high returns on capital. Earnings should not depend on transitory low tax rates and not be at risk because of high financial leverage or dividend obligations. In addition, the firm said stock option and pension costs should also be considered.

"By design or by habit, a lot of financial information has come to be in conflict with one of the simplest but truest maxims of financial reporting: numbers are not reality, they are an analog of reality," the firm said in a lengthy report.

Merrill's accounting expert, David Hawkins of the Harvard Business School, identified six measures that analysts will review when evaluating companies. These include the total return on capital, cash realization, the productive asset reinvestment rate, the tax rate, S&P's credit rating and S&P's common stock ranking. S&P ranks several thousand companies from A+ to D based on the stability in the growth of earnings and dividends over the last 10 years.

Standard Bearers

In a study, only 28 of the 404 companies analyzed by Merrill scored well across the board -- being in the top three quintiles for all six measures. Southwest Airlines ( LUV) is the highest ranked; others include Altell ( AT), PepsiCo ( PEP), ExxonMobil ( XOM), BellSouth ( BLS), ChevronTexaco ( CVX), Intel ( INTC), SBC Communications ( SBC) and Verizon ( VZ). Merrill didn't evaluate financial stocks or REITS, saying they have specialized income statement and balance sheet metrics that do not easily lend themselves to the six measures it is using.

Among industries, consumer staples ranked highest while health care was somewhat disappointing. Unsurprisingly, technology ranked last because of its low return on capital and asset replacement and low cash realization.

During a conference call Thursday morning, Merrill said that in addition to providing pro forma earnings estimates, analysts would also offer estimates based on generally accepted accounting principles. If there are big differences between the two, analysts must explain that. In its analysis, Merrill found that 78% of S&P companies use some type of non-GAAP earnings. Last year, pro forma numbers were 53% higher than GAAP results.

Late to the Show

Julia Grant, professor of accounting at Weatherhead School of Management, applauded the moves but said analysts at Merrill should have been examining all of these relationships from the start.

"It looks like they will be spending time digging into the relationship between the income statement, balance sheet and cash flow statement to make sure the accounting assumptions that were made are good ones," she said, adding that GAAP earnings aren't always wholly reliable.

Among other changes, Merrill said that as of September it will simplify its rating system, recommending stocks as buy, neutral or sell. Research reports will also include a number of new ratios including a ratio of cash flow to net income. They will also show pretax return on total capital as well as after-tax return on equity.

Of course, it is worth noting that while high-quality earnings are important over the long run, companies with good underlying strength aren't always the best-performing stocks, according to Merrill.

In an economy that is recovering from a sharp downturn, low-quality stocks often outperform higher-quality ones partly because companies with low earnings quality tend to get beaten down in a recession and can accelerate quickly from a low base, Merrill said.

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