The S&P 500's widely followed earnings estimate is dropping and you can blame Alphabet

  • Alphabet reported adjusted earnings of $11.75. If a $5 billion charge for an EU fine is included, the earnings drop all the way to to $4.54.
  • Overall earnings for the S&P 500, which had been rising, are now expected to be up 20.8 percent for the second quarter, down from 21.7 percent a day ago. That's all because of Alphabet.
  • If the Alphabet earnings number without the fine was used, the market's earnings growth rate would be 22.4 percent.
Google CEO Sundar Pichai speaks on stage during the annual Google I/O developers conference in Mountain View, California, May 8, 2018.
Stephen Lam | Reuters
Google CEO Sundar Pichai speaks on stage during the annual Google I/O developers conference in Mountain View, California, May 8, 2018.

Earnings season, for the most part, has been outstanding. Companies are almost always beating numbers and at least maintaining or raising guidance for the full year. There are a few companies complaining about higher dollar and commodity costs (Illinois Tool Works, Kimberly Clark), but they are the minority.

But that rosy outlook changed Monday night, thanks to Alphabet and the $5 billion charge they took for that big EU fine.

Here's the problem: It seriously dropped the earnings, and Alphabet is so big it is moving expectations for the whole S&P 500.

Alphabet reported adjusted earnings of $11.75, a blowout compared to analysts consensus estimate of $9.59.

However, if the $5 billion charge for the EU fine is included, the earnings drop all the way to to $4.54.

So what's the real earnings number: $11.75, or $4.54?

Thomson Reuters, one of several companies that track earnings, is, for the moment, going with the lower number ($4.54) and that lower number is having a material impact on the firm's widely followed estimates for the S&P 500 as a whole.

Overall earnings for the S&P 500, which had been rising, are now expected to be up 20.8 percent for the quarter, down from 21.7 percent yesterday.

That decline — 0.9 percentage points — may not seem like a lot, but it is a very large decline for the S&P 500 as a whole.

If the earnings number without the fine — $11.75 — was used, the earnings rate would be 22.4 percent.

This goes to the heart of an argument that has gone on for more than a decade: Should analysts use traditional "GAAP" (Generally Accepted Accounting Principles) numbers that include most charges, or should they use "Adjusted" (non-GAAP) earnings that strip out charges that will not typically be repeated?

Christine Short at Estimize, another company that tracks earnings estimates, uses non-GAAP numbers in her calculations. Her reasoning: "Every business runs differently, and every company should be able to remove charges that don't impact earnings going forward," she told me.

This is a compelling argument to a lot of investors. It's tougher to do a long-term comparison of earnings growth over several years when you have a huge charge in the middle that doesn't relate to the core business and distorts the rate of growth. This is one reason many pay more attention to, say, revenues, which for Alphabet came in up 25 percent. "That [revenue growth] makes sense over the history of Alphabet, and why we go with the non-GAAP EPS," she said.

Finally, she notes that charges typically don't impact investor behavior.

"Would a one-time charge prevent an investor from getting involved in company going forward?"

Unfortunately, if you are an old-fashioned investor, this is not necessarily a compelling argument.

What would Buffett think?

Here's a question: What would Warren Buffett think? I think I know: Mr. Buffett would likely say, "I'm sorry, but as an investor I do not have $11.75 in earnings, I have $4.54. Period."

And he would be right.

For years, many have accused Wall Street and the analyst community of "financial engineering," and this is a good example. We have been encouraged to focus on "core" earnings and ignore "charges" that don't directly relate to a company's long-term profitability, and it all hides a simple fact: To an investor who is interested in just how much earnings he or she actually has in hand at the end of the day, it's all a lot of hooey.

To its credit, Alphabet warned the analyst community about the charge and clearly indicated they would include it in their calculations. so I am not blaming Alphabet for anything. The problem I have is with the interpretation by the analyst community.

Here's what's really frustrating: David Aurelio, who compiles earnings estimates for Thomson Reuters, noted that Alphabet gave the analyst community warning that the $5 billion fine was coming, but the analysts did not drop their estimates. The analysts still decided to exclude the fine from the estimates, but after Alphabet reported Monday night, the analysts turned around and decided to include it.

"It's frustrating that they can switch," Aurelio told me.

If you want to see how confused this process has become, just look at how a company like Thomson Reuters decides whether they are going to use a GAAP or a non-GAAP number in their calculations: by simple majority of analysts. If more than half use GAAP, they go with GAAP.

In the case of Alphabet, Aurelio said there were 37 analysts, and of that 33 excluded the charge, so he went with the excluded estimate. After the report came out, the majority of analysts switched positions, he told me, thought he didn't have the exact number in front of him.

Here's the good news: in most cases, GAAP and non-GAAP numbers are not materially different. The bad news is, in a few cases it can make a big difference.