Last year, we discussed how the market still appeared to be ― for the most part uncritically ― accepting these adjusted earnings numbers. Compressed valuation multiples reflect more scepticism, and an increasing prioritisation of profitable growth over spare-no-expense growth.Īt the same time, a large proportion of S&P500 companies continue to present “adjusted” earnings numbers. The perception shift is also apparent in hyper-growth tech. The dearth of IPOs in recent months highlights how quickly investor appetite can wane. Conditions presented an opportune IPO environment, at least for sellers.įalling share prices led to reappraisals of companies’ profitability and prospects. Since 1980, the only two years with such a high proportion of unprofitable companies being listed were in 1999 (76 per cent) and 2000 (81 per cent) 3, at the peak of the Dotcom boom. Since 2017, the proportion of all companies listed that were unprofitable ranged from 75 per cent to 81 per cent. The recent era of free money suspended financial reality across swathes of the market. Rising stock prices fuel investor belief and generate a few tough questions. Why today’s market may be a better reformer In this piece, we discuss why the current environment is leading to a more realistic appraisal of companies’ financial performance, the ongoing use of adjusted earnings to boost profitability, how this may unravel (in the short-term at least), and why parts of non-profitable tech could be unlikely to bounce back and how we’re navigating these waters. But, unlike the Quantitative Easing years ― where liquidity and a bull market covered a lot of sins ― we believe in the current environment investors will be increasingly rewarded for rolling up their sleeves and doing the fundamental work of separating business fact from financial illusion. The odds of regulation successfully addressing these issues anytime soon seem low. As we’ll discuss, while some of the methods have changed, almost a quarter of century on the gamification of financial reporting continues. As Warren Buffett noted at the time, once an everybody’s-doing-it attitude takes hold, ethical misgivings vanish, and a form of Gresham’s Law takes hold where bad accounting drives out good 2. “A gray area where the accounting is being perverted where managers are cutting corners and, where earnings reports reflect the desires of management rather than the underlying financial performance of the company” 1. Back in 1998, the Chairman of the SEC announced initiatives to combat earnings management when he said: We wrote about the practice of adjusting earnings on Livewire in March last year, but the gradual erosion in the quality of earnings isn’t new. In recent years, short-term narratives have often trumped financial reality. It isn’t uncommon for management teams to systemically overstate their company’s profitability and skew the starting point for evaluating a company’s outlook. But perhaps the first question should be: are historic earnings too high? Are earnings estimates too high? It’s a question being repeatedly asked, as the market speculates about the economic outlook.
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