stockholder earnings

CFA Institute

Stockholder EarningsAuthor(s): Henry TownsendSource: Financial Analysts Journal, Vol. 46, No. 1 (Jan. - Feb., 1990), pp. 47-57Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4479296 .Accessed: 17/06/2014 19:04

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact [email protected].

.

CFA Institute is collaborating with JSTOR to digitize, preserve and extend access to Financial AnalystsJournal.

http://www.jstor.org

This content downloaded from 91.229.248.104 on Tue, 17 Jun 2014 19:04:00 PMAll use subject to JSTOR Terms and Conditions

http://www.jstor.org/action/showPublisher?publisherCode=cfahttp://www.jstor.org/stable/4479296?origin=JSTOR-pdfhttp://www.jstor.org/page/info/about/policies/terms.jsphttp://www.jstor.org/page/info/about/policies/terms.jsp

by Henry Townsend

Stockholder Earnings

A new profit series approximates total national after-tax earnings on a financial accounting

basis as reported by U.S. stockholder-owned corporations. The new series, called "stock-

holder earnings/' uses the National Income and Product Accounts (NIPA) corporate profit

measures as its base, but subtracts the profits of quasi-governmental entities, such as the

Federal Reserve banks, and includes certain items that are excluded from NIP A profits, such

as capital gains and dividends received from other companies.

Stockholder earnings is in turn used to derive several new series, including a cash flow

series for U.S. corporations and two versions of inflation-adjusted stockholder earnings. The

first of these adds to stockholder earnings deferred taxes and makes two adjustments for the

effects of inflation to convert depreciation and inventory changes to a current cost basis. The

second corrects in addition for the change caused by inflation in the real value of financial

assets and liabilities. These two inflation-adjusted series are further adjusted to remove

variations caused by cyclical movements in the economy.

Earnings/price ratios based on the inflation and cyclically adjusted stockholder earnings

and S&P 500 prices are compared with actual EP ratios to determine if investors make these

types of adjustments when estimating corporate earnings. The results suggest that investors

take into account the effects of cyclical variation and incorporate inflation effects by adding

back deferred taxes, using replacement cost accounting and removing FIFO profits. The

results suggest, however, that investors make the irrational error of capitalizing earnings

with a nominal, rather than a real, discount rate.

THE

NATIONAL INCOME and Product

Accounts (NIPAs) include three principal measures of corporate profits?(1) corpo-

rate profits with inventory and capital consumption adjustments, (2) corporate profits before

taxes and (3) corporate profits after taxes. Econ-

omists prefer the first measure as an estimate of

the portion of national income earned by corporations. Financial analysts and journalists more

often use the second or third measure.

None of these measures closely resembles

profits on a financial accounting basis (even

though corporate profits after taxes and even

profits before taxes are sometimes erroneously called "book profits"). Macroeconomic forecasts

of NIPA profit measures should thus not be

used as indicators of the average growth in book

profits, earnings or other financial accounting measures.

This article presents a new measure of profits that approximates total national after-tax earn-

ings on a financial accounting basis as reported

by U.S. stockholder-owned corporations.1 It ex-

cludes the "profits," included in the NIP As, of

nonprofit corporations and of corporations that

are quasi-governmental entities, such as the

Federal Reserve banks, and includes certain

items that are excluded from NIPA profits, such

as capital gains and dividends received from

other companies. The measure is conceptually similar to book profits, after-tax earnings or net

Henry Townsend is an Economist with the Bureau of Economic Analysis, U.S. Department of Commerce.

The analysis and conclusions contained in this article are

entirely those of the author and should not be ascribed to the Bureau of Economic Analysis, U.S. Department of Com-

1. Footnotes appear at end of article.

FINANCIAL ANALYSTS JOURNAL / JANUARY-FEBRUARY 1990 ? 47


http://www.jstor.org/page/info/about/policies/terms.jsp

income. Any of these names could legitimately be used for the series. But since it is an approximate series, derived from aggregate sources

rather than summed from company financial

reports, we call it "stockholder earnings." We then derive other new series, starting

with aggregate stockholder dividends and cash

flow. We also make several adjustments to

stockholder earnings in order to remove certain

distortions present in conventionally reported

earnings, producing two inflation-adjusted stockholder earnings series. The inflation-ad-

justed series are adjusted for cyclical variations

in profits to produce cyclically adjusted infla-

tion-adjusted stockholder earnings. We use the

new earnings series to produce new inflation-

adjusted and cyclically adjusted earnings/price ratio series, using the S&P 500 earnings/price ratio as a base. Finally, we use an econometric

model of stock prices to see whether investors in

the stock market seem to make similar adjustments.

NIPA Measures

It will be helpful to describe in more detail the

NIPA corporate profit series. Corporate profits before taxes (CPBT) measures the income aris-

ing from current production of organizations treated as corporations in the NIPAs, using

inventory and depreciation rules permitted un-

der federal income tax accounting. It is mea-

sured primarily on the basis of data collected by the Internal Revenue Service (1RS) from corporate tax returns. The NIPA and 1RS definitions

of corporate profits differ substantially, so the

Bureau of Economic Analysis (BEA) makes a

number of adjustments to the 1RS data to esti-

mate CPBT. CPBT, for example, excluder capital

gains but includes municipal bond interest and

the income of the Federal Reserve banks.

Corporate profits after taxes (CPAT) is simply CPBT after subtracting federal and state and

local corporate profit tax liabilities less credits.

Corporate profits with inventory and capital

consumption adjustments (CPADJ) differs from

CPBT by including three adjustments. The in-

ventory valuation adjustment removes from

CPBT the inventory profit or loss that occurs

when inventory withdrawals are valued at

prices of an earlier period. When inventories are

physically constant or increasing, it transforms

FIFO-based profits to a LIFO basis; such paper

inventory profits and losses do not contribute to

current production and therefore are not con-

sidered part of national income or GNP. CPADJ includes two capital consumption adjustments,

although only the sum of the two is reported in

the quarterly NIPAs. One revalues corporate

depreciation charges as reported to the 1RS to a

consistent accounting basis, using straight-line

depreciation and uniform, more realistic service

lives. The second revalues depreciation charges from a historical cost basis to a current cost

basis, so that such charges are measured using current replacement costs of the capital used in

production.

Stockholder Earnings Stockholder earnings is an estimate of the na-

tional after-tax earnings on a financial account-

ing basis of U.S. stockholder-owned corporations. It differs substantially from the NIPA or

1RS definition of profits. We use three main types of adjustments to

estimate stockholder earnings. The first sub-

tracts profits of certain institutions that are

treated as corporations in the NIPAs but that are

unlike conventional stockholder-owned corporations. For example, we exclude the large

profits of the Fed and the profits of private

pension plans (whose net inflow of dividends

becomes negative profits in the national income

accounts). The second type of adjustment changes de-

preciation charges on a corporate income tax

basis to straight-line, historical cost depreciation

charges similar to those used in financial ac-

counting. The third type of adjustment corrects cover-

age differences between the NIPA or 1RS con-

cept of income and net income on a financial

accounting basis. For example, we add capital

gains and dividends received from other corporations and subtract dividends on preferred stock. These adjustments are described in detail

in the appendix. Table I displays annual values of stockholder

earnings from 1947 through 1989.2 Two caveats

should be mentioned. First, the series is based

on aggregate data; there are few of the refine-

ments that would result from making more

finely grained adjustments at the company or

industry level. Second, there are no adjustments for some of the known differences be-

tween financial accounting and NIPA or tax

accounting. The essential information is simply not available. In recent years, for example, write-offs and foreign currency charges have

FINANCIAL ANALYSTS JOURNAL / JANUARY-FEBRUARY 1990 D 48



been large, but information on their national

totals is not available.

The existing series most comparable to stock-

holder earnings is one collected by the 1RS. In

most years since 1963, corporation income tax

return Schedule M-l has asked for "net income

per books," taxable income as defined by the tax

code and various reconciling items, such as

tax-exempt interest. Unfortunately, not all com-

panies answer the questions, but because the

question on taxable income appears both in the

main body of the return and on Schedule M-l, it

is possible, given some assumptions, to esti-

mate the missing responses. Moreover, there

are no data for four years?1967,1968,1970 and

1979?when the 1RS did not ask the question. The average ratio of total book income (as we

estimate it from this 1RS source) to stockholder

earnings for the years 1963 (when the 1RS sur-

vey began) to 1985 (the date of the latest avail-

able data) is 1.012, although it ranges from 0.84

to 1.24. Thus stockholder earnings appears to be

approximately the right size.

The most comparable orthodox NIPA series is

CPAT. CPAT is smaller than stockholder earn-

ings, and the difference has grown steadily over

time. Whereas CPAT was about 96 per cent of

stockholder earnings in 1947, by 1986 it was

only 39 per cent. The main reason for the

decline in CPAT relative to stockholder earnings is the growing difference between depreciation as measured for tax purposes and depreciation as measured for stockholder earnings. The ad-

justment used to approximate this difference

grows from only a few percentage points of

CPAT in the late 1940s to approximately 40 per cent in the 1980s.

Another interesting comparison can be made

with an estimate of total earnings for companies in the S&P 500, estimated by dividing the total

market value of the companies by the index

price per share?to get an index of the total

number of shares?then multiplying by earn-

ings per share to get total earnings.3 The aver-

age ratio of these profits to stockholder earnings is 0.44 for the years 1964-88, ranging from 0.40

to 0.50.

Series Derived from Stockholder

Earnings The first series we derive from stockholder

earnings is cash flow for U.S. stockholder-

owned corporations. To obtain cash flow, we

add to stockholder earnings depreciation and

depletion expenses and deferred taxes, while

subtracting the paper inventory profits and

losses made by corporations using non-LIFO

accounting. (The appendix describes the de-

tailed steps used to obtain cash flow.) We next derive the two inflation-adjusted

series. To obtain the first series?inflation-

adjusted stockholder earnings I?we add de-

ferred taxes to stockholder earnings and make

two adjustments for the effects of inflation. As a

practical matter, deferred taxes are rarely paid, and adding them back is a common practice for

financial analysts interested in "true" profits.4

Table I Stockholder Earnings (billions of dollars)

Inflation- Adjusted and

Inflation- Cyclically Earn- Cash Adjusted Adjusted

Year ings Flow I II I II

1947 2L4 22JL 147 1948 24.5 30.0 19.6 18.1 1949 20.5 30.7 18.0 17.9 19.4 1950 27.1 31.4 20.7 22.1 19.0 1951 24.2 33.7 19.5 20.7 15.7 1952 22.7 35.5 19.1 20.6 16.9 1953 23.3 35.9 19.2 18.9 16.3 1954 24.6 39.3 21.3 22.6 22.2 1955 31.2 46.7 28.0 29.5 25.8 1956 31.6 47.7 27.1 28.9 26.6 1957 31.0 49.8 26.6 28.2 26.5 1958 28.5 49.7 24.8 25.6 29.0 1959 34.0 56.8 30.4 32.1 29.9 1960 32.1 56.5 29.0 29.6 29.9 1961 34.4 60.7 32.0 33.0 33.0 1962 38.9 68.2 38.1 40.1 37.2 1963 42.0 72.8 41.7 42.7 40.6 1964 48.4 80.8 48.1 49.4 45.3 1965 58.1 92.1 57.4 60.1 51.8 1966 62.2 97.6 60.9 67.0 53.7 1967 62.5 101.9 61.1 64.6 56.2 1968 65.7 107.6 63.4 73.0 57.2 1969 62.9 106.6 59.7 69.4 57.0 1970 56.0 101.0 50.8 61.4 55.9 1971 65.9 116.9 60.1 72.3 64.7 1972 81.2 136.6 74.5 81.9 74.3 1973 100.2 148.4 86.4 103.8 82.0 1974 110.4 148.0 82.0 117.2 89.6 1975 106.1 175.1 82.3 106.3 98.2 1976 132.4 205.5 102.4 119.6 108.2 1977 159.8 243.9 127.2 147.1 126.5 1978 186.6 275.4 145.2 170.4 134.8 1979 217.4 302.1 159.8 192.8 155.4 1980 214.0 312.2 150.4 188.2 160.8 1981 211.2 355.6 151.3 190.7 158.5 1982 178.0 354.4 123.9 144.3 165.6 1983 227.0 426.7 188.8 202.6 212.6 1984 249.8 478.2 224.7 239.9 224.1 1985 264.6 529.4 258.3 274.5 260.6 1986 293.5 584.7 288.6 304.8 291.6 1987 305.3 580.2 278.9 300.0 266.6 1988 337.5 616.1 297.7 330.6 270.8 1989 327.8 628.0 283.1 315.1 256.9




The inflation adjustments convert depreciation and inventory change to a current cost basis.

They are conceptually much the same as the

adjustments that would be required to produce total income from continuing operations on a

current cost basis, as defined by the Financial

Accounting Standards Board (FASB) Statement

No. 33, "Financial Reporting and Changing Prices."

The first inflation adjustment is the corporate

capital consumption adjustment for current re-

placement cost, used in the NIPAs to convert

straight-line, historical cost depreciation charges to a current cost basis. This removes from stock-

holder earnings the shortfall in reported depreciation caused by using historical, rather than

current, replacement costs in calculating depreciation. The second inflation adjustment, the

NIPA inventory valuation, subtracts the paper

profits stemming from FIFO accounting. We

multiply that adjustment by the corporate pass-

through rate, for if we remove the profits we

should also remove the taxes paid on them.

The second series?inflation-adjusted stock-

holder earnings II?uses inflation-adjusted stockholder earnings I as a base, then corrects

for the change caused by inflation in the real

value of financial assets and liabilities. This

adjustment is conceptually similar to adjusting for what FAS 33 calls the "purchasing power

gain or loss on net monetary items."5

The total net financial liabilities of corporations exceed their financial assets; their net

financial liability is thus positive. Almost all of

this liability is fixed in nominal terms, hence its

nominal value does not vary with inflation. But

inflation reduces the purchasing power of nom-

inal fixed assets and liabilities, and thereby reduces the real burden of the net financial

liability position. Inflation thus reduces the real

value of corporate net financial liabilities, and

inflation-adjusted stockholder earnings II in-

cludes this gain in profits. Table I gives the two

inflation-adjusted stockholder earnings series.

(The appendix describes the methods used to

derive them.) Our last two series are derived by removing

from inflation-adjusted stockholder earnings I

and II the variations caused by cyclical move-

ments in the economy. By purging stockholder

earnings of the distortions caused by both infla-

tion and cyclical economic effects, we obtain a

better reflection of the real value of stockholder

earnings; Table I gives the cyclically adjusted

series (and the appendix describes the methods

used to derive them).

Inflation and Cyclically Adjusted EP

Ratios

The S&P 500 earnings-per-share series does

not reflect replacement cost accounting, so the

S&P 500 price/earnings (PE) and earnings/price

(EP) ratios do not either. But we can now

construct a replacement cost (inflation-adjusted) S&P 500 EP series by multiplying the usual EP

ratio by the ratio of inflation-adjusted stock-

holder earnings to stockholder earnings itself.

Earnings for the inflation-adjusted EP ratio

are arrived at by multiplying the four-quarter

trailing earnings of the S&P 500 by an adjustment equal to the ratio of the four-quarter

trailing average of inflation-adjusted stock-

holder earnings I to the four-quarter trailing

average of stockholder earnings. The price is the

conventional end-of-quarter price of the S&P

500. The resulting EP series reflects depreciation and inventory, and therefore earnings, mea-

sured on a replacement cost basis.

Note that our adjustment ratio differs from

another ratio sometimes used to adjust earnings

per share?i.e., the ratio of NIPA after-tax cor-

porate profits with inventory and capital con-

sumption adjustments to corporate profits after

taxes. Both the numerator and the denominator

of that ratio are based on tax accounting and the

NIPA definition of profits, so they include the

irrelevant "profits" of institutions such as the

Fed, while excluding such components of finan-

cial profit as capital gains. It is not surprising that there are major differ-

ences between our adjustment ratio and the

conventional ratio. For 1986, when tax-based

depreciation exceeded financial depreciation by the greatest amount, our ratio is 0.983; in that

year, inflation-adjusted profits were only a bit

below profits measured by conventional finan-

cial accounting. By contrast, the conventional

ratio for that year is 1.525; adjusted after-tax

corporate profits were far above corporate

profits after taxes.

We can easily construct three more adjusted EP series. In each case, we multiply the stan-

dard S&P 500 EP ratio by the ratio of four-

quarter inflation-adjusted and possibly cycli-

cally adjusted stockholder earnings to four-

quarter stockholder earnings. Table II shows

year-end values of the four adjusted EP ratios.




Do Investors Make These Adjustments? We have constructed four adjusted EP ratios

using two kinds of inflation adjustments and a

cyclical adjustment. Each adjustment removes a

distortion present in conventionally measured

earnings, so we can argue that use of the

successive adjustments brings earnings closer to

"true" profits. Using the adjusted earnings se-

ries in turn to adjust the standard EP ratio

should remove distortions and bring the ratio

closer to its "true" undistorted value. Investors

should regard the adjusted ratios as better mea-

sures of the expected real return on equities, while corporate managements can view the ad-

justed ratios as better measures of the cost of

equity capital. The various adjustments are logically plausi-

ble, but do investors in fact make these adjustments? Surely investors make some sort of

explicit or implicit cyclical adjustments to earn-

ings, but whether or not they are motivated or

have the information to make inflation adjustments of the type we derive is another matter.

We can approach the problem via an econo-

metric model of the earning/price ratio. We

begin with a basic model that contains no ad-

justments, then add the various inflation and

cyclical adjustments, testing in each case

whether the adjustments are statistically significant. If adding an adjustment to the EP ratio

significantly improves the fit of the model, then, we reason, the adjustment removes from the

standard EP ratio a source of noise or distortion

that is removed by investors in the market.

There is no standard model of overall market

prices that can serve as an accepted starting

place. Perhaps the best we can do is to use

variables from the well known Modigliani and

Cohn equation, thus saving ourselves effort

(and, more importantly, assuring the reader

that our answers are not the results of data-

mining).6 We model the log of the EP ratio with

second-degree, eight-quarter, untied Almon lag functions of the long bond rate, the inflation

rate and a cyclical variable, the ratio of the

civilian labor force to the number of employed civilians.

The model is meant only as a base for testing

adjustments to the usual EP ratio. Details of the

statistical results are relegated to the appendix. Here we concentrate on the statistical significance of the adjustments.

First, we tested whether investors seem to

take into account the inflation adjustments in-

corporated in inflation-adjusted stockholder

earnings I. The statistical tests show that inves-

tors do seem to take them into account. Finan-

cial analysts apparently add back deferred taxes, use replacement cost accounting and remove

FIFO profits in estimating profits, and these

efforts of analysts seem to be priced in our

model of stock prices. Next, we examined the cyclical adjustment

process itself. Investors seem to recognize and

to adjust for the cyclical variation in earnings. This is hardly surprising; to find otherwise

Table II Conventional and Adjusted Earnings/Price Ratios

Inflation- Adjusted and

Inflation- Cyclically Adjusted Adjusted

Year S&P 500 I_U_/_ll_ 1947 11.05 7.58 1948 16.50 13.15 12.15 1949 13.77 12.10 12.01 13.08 13.22 1950 13.18 10.08 10.74 9.25 10.22 1951 10.23 8.24 8.75 6.67 7.50 1952 9.67 8.16 8.72 7.21 8.05 1953 9.87 8.14 8.02 6.92 7.13 1954 8.26 7.15 7.58 7.44 8.04 1955 8.03 7.21 7.60 6.64 7.21 1956 7.18 6.15 6.55 6.04 6.58 1957 8.00 6.85 7.27 6.84 7.41 1958 5.87 5.10 5.26 5.58 5.85 1959 5.28 4.73 4.99 4.50 4.89 1960 5.33 4.82 4.91 4.96 5.17 1961 4.84 4.51 4.65 4.64 4.88 1962 6.28 6.15 6.47 6.00 6.46 1963 5.62 5.58 5.71 5.44 5.68 1964 5.36 5.32 5.47 5.01 5.26 1965 5.68 5.61 5.87 5.07 5.44 1966 6.78 6.64 7.31 5.85 6.62 1967 5.74 5.62 5.94 5.16 5.57 1968 5.70 5.50 6.33 4.97 5.86 1969 6.03 5.72 6.65 5.47 6.44 1970 5.48 4.98 6.01 5.48 6.51 1971 5.25 4.79 5.75 5.15 6.12 1972 5.44 4.99 5.49 5.00 5.49 1973 8.36 7.21 8.66 6.84 8.30 1974 12.97 9.64 13.77 10.54 14.57 1975 8.62 6.69 8.63 7.97 9.75 1976 9.22 7.13 8.33 7.54 8.62 1977 11.45 9.11 10.54 9.06 10.41 1978 12.83 9.99 11.72 9.27 10.95 1979 13.77 10.12 12.21 9.84 11.84 1980 10.92 7.67 9.60 8.20 10.00 1981 12.53 8.98 11.32 9.46 11.68 1982 8.99 6.26 7.29 8.36 9.16 1983 8.51 7.08 7.60 7.97 8.36 1984 10.00 9.00 9.60 9.97 9.49 1985 6.91 6.74 7.17 6.80 7.16 1986 5.98 5.88 6.21 5.94 6.21 1987 7.08 6.47 6.96 6.18 6.63 1988 8.56 7.55 8.38 6.87 7.66 1989:11 7.93 6.92 7.88 6.29 7.20




would be tantamount to a refutation of our

model of stock prices.

Finally, we tested whether investors make the

inflation adjustment incorporated in inflation-

adjusted stockholder earnings II. This adjustment does not seem to be taken into account by investors. Adjusting earnings data with this

type of adjustment reduces the accuracy of our

model of stock prices.

Modigliani and Cohn have argued that equity investors make two types of irrational errors

when incorporating the effects of inflation in

capitalizing earnings. First, they fail to take into

account the earnings we have used as the sec-

ond type of inflation adjustment. Our results

confirm this argument, for we show that inves-

tors do not seem to take the second type of

inflation adjustment into account.

The second error noted by Modigliani and

Cohn is that investors use nominal rather than

the theoretically correct real discount rate in

capitalizing earnings. Our results offer further

evidence in support of this thesis. If investors

used a real discount rate, then the coefficient of

inflation in our models would be negative and

of roughly the same magnitude as the coefficient

of the nominal interest rate. Instead, the coeffi-

cient of inflation in our models is significantly

positive. Indeed, the coefficients of inflation and

interest rates are approximately the same size as

those estimated by Modigliani and Cohn.7

Thus, despite the evidence showing that inves-

tors take into account a variety of effects of

inflation and cyclical variation on earnings, they seem to make the irrational error of capitalizing

earnings with a nominal, rather than a real, discount rate. ?

Footnotes 1. This work was inspired and greatly aided by three

previous efforts to use NIPA data to approximate book profits. See W.W. Helman, "Economic and Investment Review" (Smith Barney, Harris Up- ham & Co., New York, Summer 1976); J.A. Gor-

man, "Relation between NIPA and Book Profits"

(Bureau of Economic Analysis, October 22, 1984); and E.M. Garzarelli, H.B. Jeffery and S.J. Fein, "Sector Analysis" (Shearson Lehman American

Express, New York, December 3, 1984). Kenneth Petrick and John Gorman of the Bureau of Eco- nomic Analysis provided essential advice.

2. Many of the data points since 1985 in the various series required to estimate stockholder earnings are estimates made by the author.

3. The total market value of the companies is unpub-

lished and was furnished by Standard & Poor/s

Corporation. As was done, for example, by B. Zwick in "Eco- nomic Analysis" (Kidder, Peabody and Co., New

York, January 10, 1986). Financial Accounting Standards Board Statement No. 33, p. 1449. See F. Modigliani and R.A. Cohn, "Inflation, Rational Valuation, and the Market," Financial

Analysts Journal, March/April 1979 and H.

Townsend, "Another Look at the Modigliani and Cohn Equation," Financial Analysts Journal, Sep- tember/October 1986.

Modigliani and Cohn estimated coefficients for real interest rates and inflation of 0.059 and 0.080 over the period of fit 1953-77; Townsend found estimates of 0.057 and 0.078 over 1953-85. The most comparable estimates here (with cyclically adjusted and inflation-adjusted earnings I) are 0.045 and 0.069.

Appendix

Derivation of Stockholder Earnings from CPAT

To derive stockholder earnings, begin with

corporate profits after tax (published as Survey of Current Business Table 8.13, line 27 (T8.13L27)). To give the reader some indication of the rela-

tive importance of the various series we use, we

will give the value, in billions of dollars, of each

series used for 1986, the most recent year for

which actual data are available for every series.

In 1986, corporate profits after tax (T8.13L27) were $115.3.

(1) Reverse four components of post-tabula- tion amendments and revisions (T8.13L2) that

should not be used in financial accounting, (a) Subtract oil well bonus payments ($0.5). The

NIPAs treat these as transactions in land and

therefore not as costs of production, (b) Subtract

an adjustment for savings and loans' earnings that substitutes for earnings data from the 1RS

other data from the Federal Home Loan Bank

Board, because financial accounting is here

closer to tax than to NIPA accounting ($6.3). (c) Add dividends received from Federal Reserve

and Federal Home Loan banks ($0.6). (d) Sub-

tract losses of foreign government actions such

as intervention, default and expropriation (ad-

justment made only in 1960 and 1971).

(2) Subtract the profits of organizations not

filing tax returns (T8.13L3, $2.9). These profits include the income of Federal Reserve banks, federal credit agencies, private uninsured pension plans, mutual depository institutions, non-




profit organizations and credit unions. Add

credits and payments to the Treasury by Federal

Reserve banks, treated as corporate profit taxes

in the NIPAs (T8.13L21, $17.8).

(3) Depletion is not recognized in NIPA ac-

counting, although it is in tax and financial

accounting. There is a NIPA depletion adjustment used to add back depletion expenses to

taxable income. But in tax accounting, using

percentage of income depletion, companies are

able to subtract far more than actual costs, while

in financial accounting depletion cannot exceed

cost. Therefore tax depletion is much larger than

financial depletion. To approximate depletion

expense under financial accounting, subtract 25

per cent of the NIPA adjustment for depletion

expense on domestic minerals (T8.13L7, $7.6).

(4) Subtract two debt adjustments. The first

adds to NIPA profits the excess of bad debt

charges over actual losses (T8.13L11, $10.5), while the second imputes income to defaulting

corporations equivalent to their defaults

(T8.13L12, $24.5).

(5) Add net capital gains, for such gains are

included in financial profits (T8.13L13, $123.7).

(6) Add dividends from domestic corporations (T8.13L14, $15.2). Financial, tax and NIPA

accounting all differ in their treatment of divi-

dends received by companies. NIPA profits, unlike 1RS profits, entirely exclude such divi-

dends, for the Bureau of Economic Analysis reasons that counting them would be double-

counting profits. Financial accounting excludes

dividends when the parent owns more than half

of a subsidiary, includes dividends and undis-

tributed profits when the parent owns from 20

to 50 per cent, and includes dividends when less

than 20 per cent is owned. For stockholder

earnings, we count all dividends received, so

we double-count the income of subsidiaries that

are over 50 per cent owned and under-count

income of subsidiaries that are 20 to 50 per cent

owned because we do not double-count the

undistributed profits of these subsidiaries.

(7) Add costs of trading or issuing corporate securities, as these costs are typically capitalized, not expensed as in NIPA accounting (T8.13L16, $9.1).

(8) To shift tax-based depreciation charges to a

financial accounting basis, and to subtract the

deferred taxes on the extra profit that ensues, add the corporate capital consumption adjustment for consistent accounting at historical cost

(T8.4L5, $127.0) multiplied by the corporate

pass-through rate ($61.9). The corporate pass-

through rate is the fraction of incremental pretax income that reaches net income, and is esti-

mated as the product of the federal pass-

through rate and the state and local pass-

through rate. The federal pass-through rate is

1.0 minus the maximum statutory corporate tax

rate. The state and local rate is 1.0 minus the

average state and local tax rate, estimated as

state and local corporate profit taxes divided by

profits before tax. Profits before tax are esti-

mated for this purpose as profits as estimated

through adjustment (7) above, plus federal, state and local corporate profit taxes, less credits

and payments to the Treasury by Federal Re-

serve banks.

(9) Neither the NIPAs nor the 1RS recognize the capitalization of interest, a financial account-

ing practice common in regulated industries

that build very costly projects with lengthy construction times. Interest costs during the

construction period are capitalized then ex-

pensed over the lifetime of the project rather

than in the year the interest is incurred. The

effect of slowing the stream of interest expenses is to increase earnings during the construction

period. To estimate the earnings increase for

electric utilities?the major source of such earn-

ings?first sum the income item "allowance for

funds used during construction" and the inter-

est charges credit item "allowance for borrowed

funds used during construction." (See Statistics

of Privately Owned Electric Utilities in the United

States, 1982 Annual, Classes A and ? Companies

(Washington, D.C.: Energy Information Admin-

istration, U.S. Department of Energy).) Take 92

per cent of that sum as the estimate of net

earnings increase due to capitalized interest, for

a BEA estimate of the resulting interest expense

averaged 8 per cent of the earnings sum over the

1971-84 period ($8.8).

(10) In financial accounting, the effect of in-

vestment tax credits may either be recognized

immediately, a practice called the flow-through method, or deferred and credited to earnings over the life of the investment on which the

credit was earned. J.T. Ball, in "Accounting for

Income Taxes," Accountants' Handbook (New York: John Wiley & Sons, 1981) says that the

deferral method is "less widely used in practice" than the flow-through method. William

Helman of Smith Barney, Harris Upham & Co., in a conversation with the author, said that

approximately one-third of total investment tax




credits are deferred, using data from the Com-

pustat file. The average lifetime of equipment is

assumed to be 13 years. Accordingly, to estimate the earnings decrease due to deferral of

investment tax credits (and, by assumption, deferral of rehabilitation tax credits and busi-

ness energy tax credits), first capitalize credits

by adding one-third of each year's new credits to a stock of credits, then multiply the stock by 12/13. Add 1/13 of this stock to earnings, then

subtract the one-third of new credits (-$3.5).

(11) Subtract preferred stock dividends, esti-

mated by multiplying total dividends (derived

below) by the share paid out in preferred divi-

dends, estimated by dividing total cash preferred dividends paid by New York Stock Ex-

change companies by total dividends paid by such companies ($8.6). (Fact Book (New York:

New York Stock Exchange).)

Quarterly values of stockholder earnings are

estimated by interpolating annual values with

the closest quarterly NIPA analogue, after-tax

corporate profits with inventory valuation and

capital consumption adjustments, less Federal

Reserve profits and taxes.

Derivation of Stockholder Dividends

To estimate dividends paid by stockholder-

owned U.S. corporations, start with NIPA div-

idends (T8.13L37, $91.3).

(1) Subtract the adjustment for post-tabula- tion amendments (T8.13L29, -$13.8). The larg- est of these adds dividends received by persons from abroad, reclassifies the return of capital by

public utilities as dividends and adjusts the

timing of dividends of regulated investment

companies.

(2) Subtract dividends paid by federal banks

and other federal credit agencies, which are

considered corporations in the NIPAs

(T8.13L30, $0.6).

(3) Subtract net U.S. receipt of dividends from

abroad (T8.13L31, $17.6), an adjustment used in

the NIPAs to add to dividends received by

corporations from abroad those dividends re-

ceived by persons from abroad. Because these

dividends are from foreign companies, we do

not include them.

(4) Subtract earnings remitted to foreign resi-

dents by nonincorporated U.S. companies that

are affiliates of foreign companies (T8.13L32,

$1.4).

(5) Add dividends received by U.S. corporations (T8.13L34, $51.1). These dividends are

removed by BEA to avoid double-counting profits.

(6) Add the earnings of U.S. residents remitted by their nonincorporated foreign affiliates, the opposite flow to T8.13L32, which was re- versed in adjustment (4) above (T8.13L35, $6.9).

Table AI gives the resulting stockholder dividends series.

Derivation of Cash Flow

To estimate cash flow, begin with stockholder

earnings.

(1) Add the adjustment for depletion ex-

penses on domestic minerals, 25 per cent of T8.13L7 ($1.9). (See adjustment (3) under "Der- ivation of Stockholder Earnings.")

(2) Add the adjustment for bad debt charges (T8.13L11, $10.5).

(3) Subtract the increase in earnings due to the

capitalization of interest ($8.8). (See adjustment (9) under "Derivation of Stockholder Earn-

ings.")

(4) Add back the decrease in earnings due to the deferral of investment tax credits (-$3.1).

(5) Add the deferred taxes on the excess of tax

over financial depreciation, estimated as the

corporate capital consumption adjustment for

consistent accounting at historical cost (T8.4L5,

$127.0), multiplied by the average corporate tax

rate, estimated as 1.0 minus the corporate pass-

through rate ($61.9).

(6) Add the NIPA corporate inventory valua-

tion adjustment, which revalues inventory withdrawals to current costs, thus removing the

paper profits stemming from FIFO accounting (T1.16L15, -$6.7).

(7) Add depreciation on a financial accounting basis, estimated as NIPA capital consumption allowances with capital consumption adjustment (T1.16L2, $285.9) plus the corporate capital consumption adjustment for current replacement cost (T8.4L6, -$73.2).

Table AI Stockholder Dividends (billions of dollars)

1947: 1952 1957: 1962: 1967: 1972: 1977: 1982: 1987:

8.3 48:9.4 49:9.6 50:11.5 51:11.2 11.2 53:11.5 54:11.8 55:13.3 56:14.2 14.6 58:14.6 59:15.8 60:16.7 61:17.5 19.0 63:20.6 64:22.7 65:25.0 66:25.6 26.4 68:29.0 69:30.1 70:30.5 71:31.7 34.5 73:40.3 74:48.0 75:43.3 76:51.9 59.4 78:66.0 79:77.0 80:86.0 81:98.4

104.9 83:104.4 84:119.3 85:128.1 86:143.4 137.3 88:153.2 89:171.7




Derivation of Inflation-Adjusted

Earnings For inflation-adjusted stockholder earnings I,

begin with stockholder earnings.

(1) Add deferred taxes, estimated as the cor-

porate capital consumption adjustment for con-

sistent accounting at historical cost, multiplied

by 1.0 minus the corporate pass-through rate

($61.9).

(2) Add the corporate capital consumption

adjustment for current replacement cost (T8.4,

-$73.2).

(3) Add the inventory valuation adjustment

(T8.8, $6.7) multiplied by the corporate pass-

through rate ($3.3).

Quarterly values are produced by interpolat-

ing annual values with quarterly values of stock-

holder earnings. For inflation-adjusted stockholder earnings II,

we wish to subtract the change in the real value

of net financial liabilities due to inflation. Unfor-

tunately, we cannot construct net financial lia-

bilities for U.S. stockholder-owned corporations, as would be needed for a precise match

with the earnings series. Although non-

financial corporations form a separate sector in

the flow-of-funds accounts, flow-of-funds data

on financial corporations mix data on corporations owned by stockholders with data on com-

panies under other forms of ownership, such as

mutual insurance companies. To make matters

worse, the flow-of-funds accounts measure do-

mestic, not national, assets and liabilities. As a

substitute for data on all national corporations, we use flow-of-funds data on (domestic) non-

financial corporations (Board of Governors of

the Federal Reserve System, Balance Sheets for the

U.S. Economy 1949-1988, October 1989). Our

liability measure is total liabilities less total fi-

nancial assets for non-financial corporate busi-

nesses excluding farms. We exclude foreign direct investment from both assets and liabili-

ties, reasoning that the value of such investment

should be approximately invariant to the rate of

inflation.

We use as the measure of the price level the

implicit deflator for gross domestic private non-

farm, nonhousing, nonhousehold product, while inflation is measured as the quarterly rate

of increase in that price. Inflation-adjusted stockholder earnings II is equal to inflation-

adjusted stockholder earnings I plus the infla-

tion rate times net financial liabilities at the end

of the previous quarter.

Derivation of Cyclically Adjusted

Earnings The cyclical adjustment process has three

steps. First, estimate an econometric equation that explains quarterly growth in earnings as a

function of inflation, real GNP and "middle-

expansion trend" GNP. Middle-expansion trend GNP is calculated by the Bureau of Eco-

nomic Analysis as part of the process of estimat-

ing the cyclically adjusted federal budget and

debt. It "smoothly connects real GNP averages in middle periods of economic expansion" (F. deLeeuw and T.M. Holloway, "Cyclical Adjust- ment of the Federal Budget and Federal Debt,"

Survey of Current Business, December 1983). We use the following notation:

QE = quarterly earnings, GNP = Gross National Product in 1982

dollars,

GNP$ = Gross National Product in current

dollars, ZGNP = middle-expansion trend GNP in

1982 dollars, GAP = (ZGNP

- GNPyZGNP,

DGAP = GAP - GAP(-l) DGAP4 = [GAP(-l) + GAP(-2) + GAP(-3)

+ GAP(-4)]/4, PGNP = implicit GNP deflator equal to

GNP$/GNP, PDOT = PGNP/PGNP(-1) -1 and

PDOT4 = [PDOT(-l) + PDOT(-2) +

PDOT(-3) + PDOT(-4)]/4.

We estimated quarterly earnings growth as

follows:

[QE -

QE(-1)]/GNP$(-1) = -0.310 DGAP

(7.3) + 0.0957 DGAP4 + 0.078 PDOT

(1.4) (0.8) - 0.116 PDOT4

(0.1) + 0.063 [ZGNP/ZGNP(-1)-1];

(0.6) R2 = 0.270; DW = 2.4;

period of fit = 1952:1-1989:111.

In the second step, substitute trend GNP for

actual GNP, and use the estimated effects of the

GAP to remove the cyclical effects of the econ-

omy on earnings. Denoting cyclically adjusted QE as CAQE:

CAQE -

CAQE(-l) =

{[(QE -

QE(-1)]/GNP$(-1) + 0.310 DGAP - 0.0957 DGAP4} ? PGNP(-l) ? ZGNP(-l).




In the third and final step, first calculate an initial series of CAQE, starting with actual QE in

the first quarter of 1948, then adding the first differences of CAQE as estimated above. Form the final CAQE series by adding to the initial

series the mean of QE less the mean of the initial

series over the period (in our sample, 1955:1

through 1981:11). At the initial and final dates of

this period, trend GNP was close to actual GNP and the economy was heading into a recession.

Thus the cyclically adjusted series has the same mean as the actual series over six complete cycles.

Annual values of cyclically adjusted earnings are annual averages of the quarterly data.

Estimated Equations To estimate the fit of our adjusted data to the

data used by investors, we use the following

inputs:

EP = four-quarter trailing earnings di-

vided by end-of-quarter price for

the S&P 500, Rl = ratio of four-quarter average of in-

flation-adjusted stockholder earn-

ings I to a four-quarter average of

stockholder earnings, R2 = a ratio similar to Rl, with infla-

tion-adjusted stockholder earn-

ings II as the numerator, Rdc = a ratio similar to Rl, with cycli-

cally adjusted stockholder earn-

ings as the numerator, Ride = a ratio similar to Rl, with cycli-

cally adjusted inflation-adjusted stockholder earnings I as the nu-

merator, R2dc = a ratio similar to Rl, with cycli-

cally adjusted inflation-adjusted stockholder earnings II as the nu-

merator, R21 = a ratio similar to Rl, with only

inflation adjustment II applied to

the numerator, R21dc = a ratio similar to R21, with a cycli-

cally adjusted numerator, RLAAA = Moody's AAA bond rate (per

cent), PDOT = percentage change at annual rate

of the implicit deflator for gross domestic private nonfarm, non-

housing, nonhousehold product, LFE = civilian labor force divided by ci-

vilian employment, used when

the dependent variable is not cy-

clically adjusted, fi(.) = second-degree, eight-quarter un-

tied Almon lag used with RLAAA, PDOT and LFE; only the sum of the

coefficients is reported.

The basic model employed is:

log(EP) = a + fl(LFE) + f2(RLAAA) +

f3(PDOT) + rho U(-l).

When the dependent variable uses cyclically

adjusted earnings, the function in LFE is omit-

ted.

All regressions use the sample period 1953:1

through 1989:11. A test of an adjustment with

the LFE variables has 132 degrees of freedom; when the LFE variables are omitted, there are

135. Estimates of the autoregressive error term

vary from 0.85 to 0.90. Table All gives the

results of the test.

To test whether investors seem to take the

first type of inflation adjustments into account, we compare the fit of the model with the con-

ventional S&P EP ratio, Equation (1), with the fit

of the same model applied to the S&P ratio with

the first type of inflation adjustments, Equation (2). An F-test of the significance of the adjustment has a value of 3.94, significant at the 95 per cent level. (Values of F(l,125) at the 90, 95 and

99 per cent levels are 2.75, 3.92 and 6.84, respec-

tively.) Next, we use the model without the LFE

variables and compare the fit with earnings adjusted only for cyclical variation, Equation (3), with the fit with cyclically adjusted inflation-

adjusted earnings, Equation (4). The F-value is

5.18, significant at the 95 per cent level. Inves-

tors seem to take the first type of inflation

adjustments into account.

Table ??

c t r- ?C ? ? r Sum O? ^ j . Sum of Coefficients for r }, Dependent ' JJ J Squared

Eq. Variable f (LFE) f (RLAAA) f (PDOT) Residuals

(1) log(EP) -5.60 0.0838 0.0244 0.9596 (2) log (EP ? Rl) -4.44 0.0542 0.0179 0.9318 (3) log (EP ? Rdc) 0.0731 0.0305 0.9577

log (EP? Ride) 0.0451 0.0236 0.9223 log(EP) 0.0533 0.0225 1.0228 log(EP-R2) -4.07 0.0516 0.0471 0.9270 log(EP-R2dc) 0.0398 0.0491 0.9250 log(EP-R21) -5.24 0.0801 0.0485 0.9534

(9) log (EP ? R21dc) 0.0674 0.0517 0.9568




Next, we examine the cyclical adjustment

process itself. First, we compare the model

without the LFE variables and the standard EP

ratio, Equation (5), with that model and the EP

ratio adjusted for cyclical variation, Equation

(3). The F-value here is 9.18, easily significant. It

is no surprise that investors seem to recognize and take into account cyclical variations in earn-

ings. Next we test whether investors seem to make

the second type of inflation adjustment. If we

compare the fit of the model with inflation-

adjusted earnings of the first type, Equation (2), with the fit of the model when both inflation

adjustments are used, Equation (6), the second

type of adjustment does not seem to matter (F =

0.68). In a comparison of the model without the

cyclical adjustment LFE variables, but with cyclical adjustment of the dependent variable,

adding the second type of inflation adjust-

ment?Equations (4) and (7)?actually worsens

the fit (F = -0.4). When we compare equation fits when only the second inflation adjustment

process, and not the first, is used (Equation (1) versus Equation (8)) again we find no evidence

that the second type of adjustment is used by investors (F = 0.86). When the second adjustment with cyclical adjustment, Equation (9), is

compared with cyclical adjustment alone, Equa- tion (3), the same result appears (F

= 0.13).




Article Contentsp. 47p. 48p. 49p. 50p. 51p. 52p. 53p. 54p. 55p. 56p. 57

Issue Table of ContentsFinancial Analysts Journal, Vol. 46, No. 1 (Jan. - Feb., 1990), pp. 1-80Front Matter [pp. 1-74]Editorial Viewpoint: AIMR = FAF + ICFA [p. 4]From the BoardDemystifying Multiple Valuation Models [pp. 6-8]

Pension Fund Perspective: Japan Bashing and the Cost of Capital [pp. 10-11]FYI: Some Doings at the Financial Analysts Seminar [pp. 13-15]Correction: Interest Rate Swaps versus Eurodollar Strips [p. 15]Managing Currency Exposures in International Portfolios [pp. 16-23]The Role of Risk in a Tax-Arbitrage Pension Portfolio [pp. 24-32]A One-Factor Model of Interest Rates and Its Application to Treasury Bond Options [pp. 33-39]Considerations in Selecting a Small-Capitalization Benchmark [pp. 40-46]Stockholder Earnings [pp. 47-57]Using Treasury Bond Futures to Enhance Total Return [pp. 58-65]Calendar Spreads for Enhanced Index Fund Returns [pp. 66-73+79]Technical NotesClosed-Form Solutions of Convexity and M-Square [pp. 75-77]Total Stock Market Value with Reciprocal Ownership: A Note on the Japanese Situation [p. 77]Is Benter Better? A Cautionary Note on Maximizing Convexity [pp. 78-79]

Book ReviewReview: untitled [p. 80]

Back Matter

stockholder earnings

Documents