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Hidden costs for pensions and stock options make corporate earnings suspect and some stocks overvalued

by Wayne Cheveldayoff, 2003-08-03

Many North American companies have hidden pension plan deficits and, additionally, are not deducting the cost of stock options. For some, this is causing corporate earnings to be drastically overstated and stock prices to be overvalued.

Unfortunately, it is difficult for investors to know which companies this applies to without doing a lot of digging into the fine print of financial statements and, perhaps, obtaining an advanced accounting degree.

The P/E (price-earnings) ratio, a valuation measure commonly used by investors, is not a reliable guide for some companies and can no longer be used with confidence to judge whether a stock is undervalued or overvalued, or to compare one company with another.

The drawback of using the P/E ratio was highlighted recently in a report by New York-based UBS accounting analyst David Bianco, who concluded that “the quality of earnings for the S&P 500, from an accounting standpoint, is the worst it has been in more than a decade.”

His report identified three areas where companies are using “aggressive” accounting practices to make earnings seem higher than they really are: (1) rosy pension assumptions; (2) not subtracting from earnings the cost of stock options; and (3) claiming certain costs to be special one-time events and thereby excluding them from earnings calculations.

His painstaking analysis of the financial statements of each of the S&P 500 companies found earnings were being overstated by 18 per cent in 1991. By 2002, the overstatement had grown to 41 per cent, partly because pension plans had suffered stock market losses over the past three years.

This meant that investors, who thought they were paying roughly 19 times the earnings of S&P 500 companies to own the index last year, were really paying almost 25 times earnings after the adjustments for the three items.

In using such aggressive accounting, companies are not breaking any rules or laws. Rather, they are simply exercising the discretion allowed under generally accepted accounting principles (GAAP).

For example, in the case of defined-benefit pension plans, company management has the flexibility to choose the expected long-run return assumption used by actuaries in determining whether a plan is in surplus or deficit.

Despite negative stock returns for three years and a dramatic change in the investment environment, many companies are still assuming their plans will continue to earn as much as 10 per cent a year in the future. Expected future annual returns in excess of 8 per cent are still quite common. By keeping these projected returns high, companies tone down the losses and keep reported earnings higher than they otherwise would be.

A recent Canadian study of 263 corporate pension plans by the Dominion Bond Rating Service (DBRS) showed that 84 per cent had a funding deficit (based on the company’s own assumptions) at the end of 2002. However, if realistic assumptions of future returns had been used, the proportion would likely have been higher.

The DBRS study pointed to another difficulty in assessing earnings. Because of accounting rules, the value of pension assets is “smoothed” over several years. As a result, 30 per cent of the pension plans studied by DBRS reported a profit from their pension plans on their financial statements in 2002, even though the plans actually lost money.

Stock options are another analytical minefield. Companies can choose whether to deduct the cost of options or simply note the cost in the notes at the end of the financial statements. Thus, unless investors check the fine print, they won’t know if a company has deducted this cost from earnings.

Adding to the analytical complexity is the fact that the reported cost of stock options can be manipulated by management through its choice of assumptions used in the standard formula to determine this cost, such as for the estimated future volatility of the company’s share price or the estimated risk-free rate of return (usually tied to prevailing interest rates).

A recent study by three Canadian business professors—Christine Wiedman from the University of Western Ontario and Heather Weir and Mark Huson from the University of Alberta—found that in the extreme case of a company choosing the most favourable assumptions for variables in the formula, the value of the options could be understated by more than 90 per cent.

Also, the differences between Canadian and U.S. GAAP make cross-border comparisons treacherous. Canadian electronics manufacturer Celestica reported for 2002 under both systems. Under U.S. rules, Celestica reported that the cumulative cost of options issued in 2002, including those granted in prior years that vested in 2002, was $130 million. Under Canadian rules, Celestica only valued new options granted in 2002 and showed a cost of $3.3 million.

All this demonstrates that stock picking is as difficult as ever. For companies with defined-benefit pension plans and stock options, investors have to dig a lot deeper than reported earnings to get a meaningful picture of the bottom line.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. He can be contacted at

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©2003 Wayne Cheveldayoff