Most investors do not realize that earnings, earnings per share and earnings growth are only accounting data and should not be relied upon for making investment decisions because:
- Accounting rules were not designed for equity investors. They were designed for debt investors.
- Corporate America and Wall Street manipulate accounting rules to report the earnings they want to show.
Think of accounting data as just the words of the language of Finance (See Finance 101). Without proper structure, words have no meaning. With bad structure, words can be misleading. The same is true for accounting data, i.e. the data companies provide in annual reports, press releases etc. Companies rarely, if ever, speak finance to investors. They only provide accounting data b/c that is all the SEC requires – AND because accounting rules provide loopholes that enable companies to manipulate earnings, a well-known fact that has gone unaddressed for some time despite some empty saber-rattling. This 1999 Fortune article,”Lies, Damned Lies, and Managed Earnings“, makes this point perfectly. You can learn more by doing a quick internet search on accounting loopholes, accounting tricks, etc.
There are many excellent books, a few are listed below, that delve deeply into this topic as well.
- Valuation: Measuring and Managing the Value of Companies by McKinsey and Co.
- Creating Shareholder Value by Alfred Rappaport
- The Quest For Value by Bennett Stewart
- Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports by Howard Schilit.
Wall Street likes using and referring investors to accounting data because they can make it say whatever they want. Wall Street firms care more about selling stock (which make money) than selling research (which does not make money). That’s right…research is a pure cost center for investment banks. Naturally, it is not in these firms’ best interests to write research that does not help them sell stock. Accounting data provides many tools for making the numbers look good enough to sell stock.
This fact is backed by the Global Research Settlement, which involved heavy fines for Wall Street. Despite those fines, the game has not changed.