How to: Earnings

Earnings are the most ubiquitous financial metric there is, but they are actually a little opaque and maybe not all that useful. In a world where more investments are intangible earnings can be a distorted metric.

First, we should start what understanding where earnings come from. Here is a simple income statement.

Cost of Goods Sold (COGS) refers to the unit cost to sell a good (for example the cost of a retailer's inventory).

Selling General, and Administrative (SG&A) is a little bit of a black box which would include expenses that are not included in COGS. Some companies will break out advertising or research and development separately, but if not, they fit into SG&A.

Due to accounting rules, assets the company buys (like a factory or building) are deprecated and counted as a Deprecation Expense. In practice this means an asset a company buys today will not count as an expense when they first buy it, but over time and boosts earnings in near term.

Interest Expense is the amount a company pays on its debt.

Income Tax Expense is the amount a company pays in taxes on its earnings.

And Net Earnings is what you have left over.

SO, what makes earnings a challenging metric is that it can be easily manipulated by moving expenses around. Companies have some discretion when they take expenses... And some like General Electric have famously been caught doing too much manipulation.

Critically, what counts as an expense and what can be depreciated (meaning counted as an expense in the future) can be misleading. Paying $1M for a tangible investment (i.e a machine) will be deprecated over time (possibly a $100,000 expense a year) while

intangible investments like research and development or advertising are expensed real time. In a research report done by Michael Mauboussin at Morgan Stanley, he estimated earnings for the S&P would be about 12% higher if intangible investments were able to be expensed. (wowza)

Asset light industries like technology typically have fewer tangible assets and more intangible assets, which may result in the understating of business performance vs more asset heavy companies.

While much of the finance world talks about earnings, it is actually better practice to focus on a company's cash flows where comparisons between investment expenses are treated fairer between different types of companies.