Investing 101: Understanding Core Earnings

If you want to start doing your own stock picking, it’s important to understand the fundamentals of how to evaluate a company and its financial performance. As part of an ongoing series, we’re providing some lessons from the experts at Minyanville. To see previous posts in this series, check out the archives.

How can you tell what a company’s true profit really is?

The “bottom line” of the income statement, or net earnings, is a widely understood dollar value. Also called profit or net profit, it is the amount left over after deducting all costs and expenses from revenue. But it is not the “real” profit a company earns. For that you need to track core earnings.

This is a calculation that adjusts net income to add or remove specific income statement entries. The purpose is to isolate the company’s core earnings, which are those earnings from its primary market activity. Excluded are non-recurring or non-core items on the statement. This is not a minor adjustment in every case; for some companies, the difference between reported net earnings and recalculated core earnings can be substantial.

Here are some examples of what gets taken out of net income to arrive at core earnings:

– gains from pension investing

– income from selling capital assets

– settlements of litigation and insurance claims

– expenses for employee stock options

The calculation gets technical for some items, but the important thing to remember is that core earnings are a more accurate estimate of the true year-to-year earnings from operations. Some companies, such as Wal-Mart (WMT), report practically no annual adjustments between net income and core earnings. For the most recently reported three years, Wal-Mart reported (in millions of dollars):

Year net earnings core earnings

2011    $ 15,959        $  15,355

2010       14,414            14,414

2009       13,254            13,505

Given the size of these profits, the very small adjustments are inconsequential. The picture is less consistent for a company reporting approximately the same levels of annual net profits. Here is IBM’s (IBM) yearly profits for the past three years:

Year net earnings core earnings

2010    $ 14,833        $  13,883

2009       13,425            12,648

2008       12,334              8,340

Although IBM net and core were closely matched in the two most recent fiscal years, 2008 was a different story, with one-third of its net profits adjusted downward to arrive at core earnings. That was significant and, if analysts recognize the importance of the adjustment, it affects virtually all of the popular ratios and indicators, including price-to-earning, net return, and the revenue-to-earnings trend.

Another company, DuPont (DD), has had a chronic annual adjustment between net and core. Since the inception of the calculation less than a decade ago, DuPont has been among the more volatile companies for the core calculation. The three most recent fiscal years were:

Year net earnings core earnings

2010    $  3,031           $  3,112

2009        1,755               1,543

2008        2,007                 677

The dollar values in this case are not as great as those for the two other companies. However, the 2008 adjustment reduced reported net earnings by two-thirds. This gives a good indicator of how important core earnings adjustments are in the accurate reporting of profits. The effect on most financial ratios is potentially great enough to make the difference between picking or rejecting a company as an investment.

To find core earnings adjustments for each year, the best source is the S&P Stock Reports, which are provided free of charge to investors and traders on several of the more popular online brokerage firms. For example, customers with accounts at Charles Schwab and E*Trade can access the S&P Stock Reports for all companies for whom the analysis is performed.

Michael C. Thomsett is author of over 60 books, including Annual Reports 101 (Amacom Books Press), Trading with Candlesticks (FT Press) and the recently released new book, Getting Started in Stock Investing and Trading (John Wiley and Sons).  He lives in Nashville, Tennessee and writes full-time.