Dr. Arthur Laffer is an incredibly intelligent economist. There are many people (this author included) who lay substantial credit at his feet for his part in convincing the Reagan administration to cut taxes, thus launching the start of nearly two decades of unimpeded growth. His eponymous "Laffer Curve" suggested that a reduction in the marginal tax rates would have the effect of increasing tax revenues for the government through increased economic activity and producing incentives for people to dream up money-making, as opposed to tax-avoiding activities. Some brand Dr. Laffer a charlatan, others are surveying sites for his statue.
As Jonathan Laing notes in "Altitude Adjustment," an article running in this week's Barron's, Dr. Laffer is no stranger to controversy. Which is all well and good because in this particular article, Dr. Laffer explains his supposition that stocks are spectacularly undervalued, that the true P/E of the S&P 500, once the adjustments he adds to make them more representative, is in the range of 3.3.
No, that's not a misplaced decimal. Dr. Laffer believes that the price the S&P 500 companies under Generally Accepted Accounting Principles (GAAP) -- about 30 times earnings -- is off by a factor of 10. Laing describes the adjustments needed to come to this number as "heroic," but gives Dr. Laffer plenty of leeway to arm wave and make adjustments. There is a distinct possibility that I misunderstand what Dr. Laffer's saying, or worse, that his original thesis was butchered in the process of going from his head to the Barron's pages, but some of the suppositions in the piece are bizarre.
The thrust of his argument is thus: All of the non-cash adjustments that GAAP requires have a significant dampening on the true economic returns companies actually generate. A proliferation of one-time charges, and capital gains and writeoffs, not to mention the changes in tax laws, mean that a comparison of GAAP earnings today with ones of even a decade ago is worthless.
All of this means that Dr. Laffer, instead of using GAAP earnings, uses a statistic called NIPA, the National Income and Product Accounts. NIPA is the tax receipts from all 5 million-plus publicly traded and private American businesses. Dr. Laffer correctly points out that there is much less incentive for corporations to overstate earnings for tax purposes, since doing so would require them to stroke a larger check to the taxman. Corporations even manage to --gasp! -- expense their stock options on exercise on their tax returns. But IRS documents are private -- you cannot see a company's tax return documents, so there's a substantial mismatch between the performance of the 500 companies constructing the S&P 500 and the 5 million that comprise NIPA. Dr. Laffer brushes this off, making one of his many "adjustments," normalizing NIPA for the S&P.
In the lower tax environment of today, earnings are worth more to the investor. Dr. Laffer contends that using four quarters of past earnings to value a company is crazy, so he uses the most recent quarter and attempts to extrapolate the future using seasonal adjustments. And finally, since historically P/E's are higher in low interest rate environments, and lower in higher environments.
Really, what gets me is the absurdity of the entire exercise, and more to the point, the absurdity of the presentation. One thing that we cannot discount is the possibility that either Mr. Laing or his editors simplified Dr. Laffer's thesis for the sake of the article, but I'm baffled that some of the statements that were published went unchallenged.
For example:
1) The article says: "For instance, new rules requiring write-downs for impairment of goodwill and other intangible assets have led to multibillion-dollar charge-offs at companies such as Time Warner (NYSE:TWX), Lucent (NYSE:LU), and Cisco Systems (NASDAQ:CSCO), dramatically hurting S&P earnings in the recent bear market."
Time Warner did have a write-down for goodwill, but both Cisco and Lucent had multi-billion dollar write-downs associated with inventory and bad loans. Those were most certainly not intangible, they were so tangible, in fact, that Cisco, at least, was later able to sell a portion of the written-down goods at an accounting gross margin of 100%. It makes no sense at all to adjust for these -- earnings are only of any value at all to shareholders when ultimately utilized to their benefit. Earnings retained by a company only to be blown on worthless inventory or bad loans are worth no more than nothing to the shareholder, and in some cases, even less than that.
2) From the article: "The NIPA definition of earnings hasn't changed in years, making for more accurate historical comparisons. And NIPA earnings exclude much one-time stuff, such as capital gains and losses, bad-debt write-downs and dividends."
Bad debt is not a one-time expense, and as bad debt generally reflects partial or total loss of an asset, the thought of ignoring it is baffling. I'm also wondering where they found dividends on the income statement. Dividends are not treated as current expenses, they're reflected in cash flows from investing and reduce shareholder equity, not earnings.
3) Again from the article: "Likewise, GAAP earnings suffer from volatile swings as a result of one-time charge-offs and the outsized impact on earnings of balance-sheet events. An example: The swings in corporate earnings in the past few years as a result of appreciation, followed by depreciation, in the stock values of defined-benefit pension plans carried on company balance sheets."
The Financial Accounting Standards Board (FASB) allows pensions to be accounted for on an actuarial, not actual results basis. These results are already smoothed -- companies' earnings are not impacted by the ebb and flow of pension assets and liabilities -- which is how General Motors (NYSE:GM) was able to report gains on its pension assets in 2002 of $7 billion even though the pension actually lost $4 billion. The swings are already taken care of through FASB's Statement 87.
4) Back to Dr. Laffer and Barron's: "Laffer adjusts his indexed NIPA P/E index to reflect other factors he says practitioners of traditional P/E analysis mistakenly overlook. Foremost, he believes P/Es should be adjusted to reflect that multiples typically rise in low-interest-rate environments and fall, often sharply, as rates rise. This is because stock prices reflect the present value of a discounted stream of future after-tax earnings."
This statement I found to be stunning on a few points. First of all, when discounting cash flows it doesn't make sense to adjust the entire stream simply because of what rates are today. And note the different terms "after tax earnings" -- which Dr. Laffer uses -- and "cash flows," the typical base upon which valuations are built. If we go with the supposition that earnings are not a reliable indicator, something with which I partially agree, we still have cash flows as a fail-safe. There's an adage that while earnings are opinion, cash is fact.
So, while any good financial analyst makes some adjustments, to my mind the ones proposed by Dr. Laffer simply seem delusional. If earnings are so unreliable today, you would think that they would be wildly divergent from operating and free cash flows. They aren't, and while there is some widening between reported earnings and free cash flow of the S&P 500 companies, it is nowhere near the orders of magnitude required for the adjustments Dr. Laffer suggests to make sense.
Again, it's possible that I simply don't understand what Dr. Laffer is saying, so I called in my own smart guy -- Professor Paul Miller from the University of Colorado at Colorado Springs, co-author with Paul Bahnson of Quality Financial Reporting. According to Miller, "What's being presented here is well outside the realms of financial accounting. That's fine, it's what the folks at Stern Stewart do with their Economic Value Added calculations. That's a financial analysis issue, not a financial reporting one."
One of my basic issues with the piece is the thought of taking the results of 5 million companies -- the totality of the corporate tax receipts in America -- and extrapolating a valuation for 500 big companies. If Dr. Laffer is claiming what the article implies, he's taking a macroeconomic statistic and applying it in a microeconomic situation. I don't see how this could possibly relate to stock prices -- NIPA even ignores the foreign sourced income for American companies. With the exception of Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE), can you really assume that American companies' domestic operations are reasonable proxies for their total operating results? How can NIPA possibly be related to a stock price?"
I wish I knew. What we could not see from this article was much in the way of Dr. Laffer's substantiation, and what commentary exists is rife with error. His point -- that the stock market actually sits at bargain levels not seen for 34 years -- doesn't hold up when you take a look at cash flow generation levels at most major companies. But Dr. Laffer's thesis, as presented in Laing's article, looks to be little more than a series of fuzzy rationalizations. I don't understand how it is that Barron's allowed them to go by without question.
Fool on!
Bill Mann, TMFOtter on the Fool discussion boards
Bill Mann has a P/E of 11. Which is higher than 10. He is the editor of Stocks 2004, The Motley Fool's Stockpicking Guide for the new year (on sale now!). He holds none of the companies mentioned in this story.
