Understanding the income distortion, the difference between core earnings and GAAP earnings, gives investors a better view of fundamentals and stock valuations. Below, I present the companies and sectors with the greatest profit distortion, both overestimated and underestimated, in the S&P 500.
S&P 500 constituents with the most under / overestimated earnings
Figure 1 shows the S&P 500 companies with the greatest profit distortion through 1Q21. I provide details below on the causes of the income distortion for two companies, AT&T (T) and Berkshire Hathaway (BRK.A).
Figure 1: S&P 500 companies with the most undervalued / overvalued earnings: TTM in 1Q21
AT&T Non-Operating Items Underestimate Profits
According to Figure 1, AT&T has the most underestimated profits after 1Q21. In its 10-K 2020 and 1Q21 10-Q, AT&T disclosed several unusual items that were hidden in the footnotes of its documents. Detailed below, these hidden and reported unusual items amount to more than $ 15.4 billion in 1Q21 TTM profit distortion and significantly (629%) skew AT&T GAAP profits.
Unusual hidden objects, net gain = -1.7 billion dollars
- $ 1.2 billion in termination costs and employee benefits losses – Page 83 2020 10-K
- $ 900 million gain on spectrum transaction – Page 83 2020 10-K
- Gain of $ 119 million on investments, net of impairments – Page 6 1Q21 10-Q
- $ 82 million loss before taxes – Page 92 2020 10-K
- $ 68 million in pre-tax gain – Page 91 2020 10-K
- $ 57 million in severance costs and employee benefits losses – Page 14 1Q21 10-T
- $ 39 million in pre-tax gain – Page 92 2020 10-K
- $ 20 million gain on buybacks – Page 26 1Q21 10-T
Unusual items reported, net gain = – $ 17.5 billion
- $ 18.9 billion in impairment and abandonment of assets – Page 66 2020 10-K
- $ 4.2 billion in other revenues – Page 3 1Q21 10-Q
- $ 1.4 billion in other expenses – Page 66 2020 10-K
- Adjustment of $ 607 million for profit distortion offsetting recurring pension costs disclosed in non-recurring items
In addition, I made an adjustment of $ 3.8 billion for the income tax distortion. This tax adjustment normalizes taxes on reported profits by removing the impact of unusual items.
After removing the profit distortion, which totals -2.14 $ / share, or -629% of GAAP EPS, I see that AT & T’s TTM 1Q21 basic profit of $ 1.80 / share is significantly higher than earnings. GAAP of – $ 0.34 / share.
Berkshire Hathaway’s overvalued earnings
Many investors are aware of Berkshire Hathaway’s large unrealized gains in 2020, as Warren Buffett spoke out on the change in accounting rule that made Berkshire’s “bottom line” unnecessary. However, the company has several other unusual items hidden and reported in its 2020 10-K and 1Q21 10-Q that make its profits even more overstated. Detailed below, the unusual items amount to more than $ 90.8 billion in 1Q21 TTM profit distortion and significantly (87%) distort GAAP profits.
Unusual hidden objects, net gain = – $ 1.2 billion
- $ 850 million intangible asset impairment charges – Page K-86 2020 10-K
- $ 180 million in after-tax acquisition accounting costs – Page 33 1Q21 10-T
- $ 10 million in sublet income – Page K-90 2020 10-K
Unusual items reported, net loss = $ 117.4 billion
- $ 55 billion change in unrealized investment gains during the year on securities held at the end of the period – Page K-87 (Page 89 overall) 2020 10-K
- $ 10.7 billion in goodwill and impairment of intangible assets – Page K-72 (Page 74 globally) 2020 10-K
- $ 4.6 billion change in period investment gains on securities held at period end – Page 10 1Q21 10-T
In addition, I made an adjustment of -25.3 billion dollars for the income tax distortion. This tax adjustment normalizes taxes on reported profits by removing the impact of unusual items.
After removing the earnings distortion, which stands at $ 57,787 / share, or 87% of GAAP EPS, I see that Berkshire Hathaway’s TTM 1Q21 base earnings of $ 8,209 / share is significantly lower than GAAP earnings. of $ 66,141 / share.
S&P 500 Core Profits vs. GAAP profits
S&P 500 core earnings fell from a high of $ 1.3 trillion in 2Q19 to $ 1.1 trillion in 4Q20 before rebounding to $ 1.2 trillion in 1Q21. Meanwhile, GAAP profits jumped from $ 1.2 trillion to $ 879 billion and rebounded to $ 1.1 billion during the same period.
Figure 2 shows the large disconnect between core earnings and GAAP earnings throughout 2020, which is largely the result of record write-downs that pushed GAAP earnings down. Before rebounding in 1Q21, GAAP profits were underestimated by $ 179.5 billion in 4Q20, more than at any time since 2009 following the financial crisis. Such a disconnect means that the “record” beats are based on an artificially lower basis while the true core earnings of the S&P 500 companies, while depressed, have never been lower.
Figure 2: Basic Profits of the S&P 500 vs. GAAP: 2004 – 1Q21
This core earnings analysis is based on aggregated TTM data for the index constituents.
Rank Sectors by Core Earnings Growth
A closer look at the S&P 500 sectors reveals that all but four sectors (real estate, consumer discretionary, industrials and energy) saw a year-over-year increase in core earnings in 1Q21. This broad-based improvement in core earnings stands in stark contrast to last quarter, when only four sectors recorded year-over-year increases in core earnings.
Figure 3 ranks the 11 sectors of the S&P 500 based on the change in core earnings from 1Q20 to 1Q21.
Figure 3: 1Q21 core earnings vs. Last year by sector S&P 500
This basic profit analysis is based on aggregated TTM data for industry constituents.
The tech sector generates the most core profits by far (nearly 1.5 times the next closest industry) and increased core profits 21% year-on-year in 1Q21. On the flip side, the energy sector has the lowest core profits and the largest year-on-year decline in 1Q21.
Get quarterly updates on the S&P 500 and its sectors
Each quarter, I provide the latest overview of core earnings and GAAP earnings for the S&P 500 and each of its sectors.
In addition to the basic results, I provide an analysis of fundamental market and sector trends in the S&P 500 and sectors: ROIC vs. WACC until 1Q21, S&P 500 and sectors: Free Cash Flow Yield until 1Q21 and S&P 500 and sectors: Price-to-Economic Book value until 1Q21. In addition, I provide a similar analysis of an all cap index, the NC 2000.
Details on the differences between basic earnings and GAAP earnings for each sector can be found in the S&P 500 and Sectors: Basic earnings vs. GAAP earnings through 1Q21.
Disclosure: David Trainer, Kyle Guske II, Alex Sword, and Matt Shuler receive no compensation for writing about a specific action, style, or theme.
Annex: Calculation methodology
I derive the above GAAP core earnings and earnings measures by summing the individual S&P 500 constituent values for the past twelve months for core earnings and GAAP earnings in each industry for each measurement period. I call this approach the “Aggregate” methodology.
The Aggregate methodology provides a straightforward snapshot of the entire industry, regardless of market capitalization or index weight, and is the way S&P Global (SPGI) calculates metrics for the S&P 500. The most recent values for basic earnings and GAAP earnings are based on the latest audited financial data, which matches the 1Q21 10-Q schedule for most companies.  Seeing the differences between S&P Global core earnings and operating earnings in S&P 500 is always valued for continued earnings rebound.  May 19, 2021 is the earliest date for which all 1Q21 calendar 10-Qs for S&P 500 components were available.