by Larry Swing - October 30, 2005

Education

A recent study, "The Predictive Value of Expenses Excluded from 'Pro Forma' Earnings" written by Jeffrey T. Doyle, Russell J. Lundholm and Mark T. Soliman from the University of Michigan Business School explored the differences between pro forma earnings and GAAP earnings. 

Pro forma earnings exclude certain gains and losses that management believes are not important or do not help investors and creditors to understand the true value of the business.  The paper by Doyle et al, however, shows that management is generally too aggressive in excluding items; they find that one dollar of excluded items predicts over three dollars in fewer cash flows over the subsequent three years; they find one dollar of non-special excluded items predicts over six dollars in fewer cash flows over the subsequent three years.

The authors tested a hedge strategy that sold stocks with high total exclusions, and bought stocks with low total exclusions.  They found that the average hedge returns for three-year periods was 11.3%.  A similar test with non-special item exclusions only generated an average return of 29.9%.  Returns for shorter time periods (one or two years) were much smaller, but were still statistically significant for a one year period (at the 1% level).

The authors found the abnormal returns to be robust after controlling for varying firm betas, sizes, book-to-market ratios, earnings-announcement effects, price momentum effects, and accrual effects.

Data in the study spanned from 1988 to 1999, and was taken from Compustat, IBES, and CRSP.

Reference:

Jeffrey T. Doyle, Russell J. Lundholm and Mark T. Soliman, "The Predictive Value of Expenses Excluded from 'Pro Forma' Earnings," January 2003.

Sectors and Markets:  Our Perspective

BBH:  Neutral.  (Biotechnology)

BDH:  Bullish.  (Broadband)

SwingTracker
MrSwings Real-Time Stock Charts RISK-FREE TRIAL featuring one-click access to Larry Swing's profit-generating indicators - Force Index, EquiVolume, True Strength Index

BHH:  Neutral.  (Business to Business)

EKH:  Neutral.  (European Stocks)

HHH:  Neutral.  (Internet)

IAH:  Neutral.  (Internet Architecture)

IIH:   Neutral.  (Internet Infrastructure)

OIH:  Neutral.  (Oil Services)

PPH:  Neutral.  (Pharmaceuticals)

RKH:  Neutral.  (Regional Banks)

RTH:  Neutral.  (Retail)

SMH:  Bullish.  (Semiconductors)

SWH:  Neutral.  (Software)

TTH:  Neutral.  (Telecommunications)

UTH:  Bullish.  (Utilities)

WMH:  Neutral.  (Wireless)

SPY:  Neutral. (S&P 500)

QQQQ:  Neutral.  (NASDAQ 100)

DIA:  Neutral.  (Dow Jones Industrial Average)