Move over stock options, there's a new issue muddying the investing waters: pension fund costs.

Standard & Poor's today released "core earnings" figures for the companies that make up the S&P 500 index, and the results are a real eye-opener -- and cause the index's P/E ratio to jump dramatically. In calculating core earnings, the organization focuses on "after-tax earnings generated from... principal businesses." And this year, that means properly accounting for stock option grant expenses and pension incomes.

For the 12 months ended June 2002, the index earned $26.74 per share, as reported by the companies themselves. Using the core earnings definition, however, that figure shrinks to $18.48 per share. The most significant impact came from the pension fund adjustment, which knocked $6.54 per share off the $26.74 figure.

Here's the problem: Generally accepted accounting principles (GAAP) allow companies to use expected returns for their pension plans. In most cases, that means 9% or 10% per year. The problem is that's an aggressive assumption, especially in the current environment. S&P's Kenneth Shea told The Wall Street Journal that all but two of S&P 500 companies with traditional pension plans actually suffered investment losses in their funds last year.

So, the S&P core earnings figure uses actual pension fund results, and thus paints a more realistic picture of the index's performance. The impact on basic metrics, such as the P/E ratio, is huge. Using "as-reported" figures, the S&P 500 is trading at 37 times trailing-12-month earnings. But using core earnings, the P/E jumps to 54.

Of course, to place that number in proper context, we'd need historical data that used the same methodology, but that's not available now. Regardless, the S&P core earnings figure points out, once again, how dangerous it can be to evaluate companies using only easily manipulated GAAP figures. As always, we recommend free cash flow, which cannot easily be faked.