We have updated the trailing-twelve-month (TTM) Core Earnings and GAAP Earnings for the NC 2000 and all sectors for 3Q23.

Seeing GAAP Earnings move in the opposite direction of Core Earnings raises red flags about the quality of reported earnings while also raising the risk of earnings misses in coming quarters. In other words, 4Q23 earnings season could be ugly. These results underscore the more stable nature of Core Earnings. Because we remove unusual gains and losses, Core Earnings are not prone to the large swings seen in GAAP Earnings.

This report is an abridged and free version of All Cap Index & Sectors: GAAP Vs. Core Update for 3Q23, one of our quarterly reports on fundamental market and sector trends.

The full version of the report analyzes Core Earnings[1][2] and GAAP earnings of the NC 2000 and each of its sectors (last quarter’s analysis is here) from 1998 to present. The full reports are available to Professional and Institutional members.

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GAAP Earnings Are Again Misleading in 3Q23

Our superior fundamental data protects investors from being fooled by misleading trends in un-scrubbed GAAP Earnings. Looking beyond the headlines reveals that the recent changes in GAAP Earnings may be an illusion for three reasons:

  1. Unusual gains are artificially elevating GAAP Earnings and cannot persist forever.
  2. Core Earnings growing slower suggests GAAP Earnings have limited room to rise.
  3. Understated GAAP earnings in prior quarters (kitchen sink effect) set up easy comps and may cause expectations for future earnings to be too high.

If the rise in GAAP Earnings proves to be an illusion, investors could be in for a tough 4Q23. See Figure 1 in the full report.

Core Earnings Are Less Volatile than GAAP Earnings

Figure 1 in the full report shows GAAP Earnings for the NC 2000 meaningfully differ from Core Earnings for the fifth consecutive quarter.

GAAP Earnings Understate Core Earnings for Nearly Two-Thirds of the NC 2000 (by Market Cap)

For the TTM ended 3Q23, 61% of the companies in the NC 2000 reported GAAP Earnings that are lower than Core Earnings.

When GAAP Earnings are lower than Core Earnings, they are understated by an average of 137%, per Figure 1.

Figure 1: NC 2000 GAAP Earnings Understated by 137% On Average

Sources:  New Constructs, LLC and company filings.
We use Funds from Operations (FFO) for Real Estate companies rather than GAAP Earnings.

Key Details on Select NC 2000 Sectors

Six of eleven sectors saw a QoQ rise in Core Earnings through the TTM ended 3Q23.

The Financials sector saw the largest QoQ improvement in Core Earnings.

The Technology sector generates the most Core Earnings. On the flip side, the Real Estate sector has the lowest Core Earnings.

Below we highlight the Industrials sector and a stock with some of the most negative Earnings Distortion (i.e. understated GAAP earnings) in the sector.

Sample Sector Analysis[3]: Industrials Sector

Figure 2 shows Core Earnings for the Industrials sector, at $206.4 billion, rose 4% QoQ in 3Q23, while GAAP earnings, at $195.6 billion, rose <1% over the same time.

Figure 2: Industrials Core Earnings Vs. GAAP: 1998 – 3Q23

Sources: New Constructs, LLC and company filings. 
Our Core Earnings analysis is based on aggregated TTM data for the sector constituents in each measurement period.
The November 14, 2023 measurement period incorporates the financial data from calendar 3Q23 10-Qs, as this is the earliest date for which all of the calendar 3Q23 10-Qs for the NC 2000 constituents were available.

GAAP Earnings Understatement Details: Caterpillar (CAT)

Below, we detail the hidden and reported unusual items overlooked in GAAP Earnings and captured in Core Earnings for Caterpillar (CAT). After adjusting for unusual items, we find that Caterpillar’s Core Earnings of $10.5 billion, or $20.27/share are much higher than reported GAAP Earnings of $9.1 billion, or $17.62/share.

Caterpillar’s Stock Rating is Attractive, in part due to its rising economic earnings, high free cash flow yield, and low price-to-economic book value (PEBV) ratio of 1.0.

Below, we detail the differences between Core Earnings and GAAP Earnings so readers can audit our research.

Figure 4: Caterpillar’s GAAP Earnings to Core Earnings Reconciliation: TTM through 3Q23

Sources:  New Constructs, LLC and company filings.

More details:

Total Earnings Distortion of -$2.65/share, which equals -$1.4 billion, is comprised of the following:

Hidden Unusual Expenses Pre-Tax, Net = -$1.73/per share, which equals -$892 million and is comprised of:

Reported Unusual Expenses Pre-Tax, Net = -$1.27/per share, which equals -$659 million and is comprised of:

Tax Distortion = $0.35/per share, which equals $183 million.

This article was originally published on December 6, 2023.

Disclosure: David Trainer, Kyle Guske II, Italo Mendonça, and Hakan Salt receive no compensation to write about any specific stock, style, or theme.

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Appendix: Calculation Methodology

We derive the Core Earnings and GAAP Earnings metrics above by summing up the trailing-twelve-month individual NC 2000 constituent values for Core Earnings and GAAP Earnings in each sector for each measurement period. We call this approach the “Aggregate” methodology.

The Aggregate methodology provides a straightforward look at the entire sector, regardless of market cap or index weighting and matches how S&P Global (SPGI) calculates metrics for the S&P 500.

[1] Core Earnings enable investors to overcome the flaws in legacy fundamental data and research, as proven in Core Earnings: New Data & Evidence, written by professors at Harvard Business School (HBS) & MIT Sloan for The Journal of Financial Economics.

[2] Based on the latest audited financial data, which is the 3Q23 10-Q in most cases. Price data as of 11/14/23. QoQ  analysis is based on the change since last quarter’s report.

[3] The full version of this report provides analyses for all eleven sectors.

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