Adjusted Earnings Yields and Real Rates of Return

An accurate forecast of real return requires that accounting and debt adjustments be made to reported earnings. This article presents methodologies that investors can use to estimate the accounting and debt adjustments for individual companies and offers evidence, derived from a predictive regression model, that investors should consider these adjustments important. The article also reviews the use of nonfinancial corporate debt and makes the case that investors should view the use of debt by nonfinancial companies more positively than they currently do. In this article, the authors present methodologies that investors can use to estimate the accounting and debt adjustments for individual companies. These adjustments should be considered important because survey data have shown that earnings are preferred over cash flow, dividends, and book value as a valuation input. The accounting adjustments reflect the adjustments that must be made to GAAP-reported earnings to convert them from a historical-cost into a current-cost accounting system. A current-cost accounting system requires that assets be valued at their replacement cost. Thus, these adjustments would reduce reported earnings when prices are increasing. The authors’ first accounting adjustment is to cost of goods sold for those companies that choose the FIFO method of inventory accounting. The adjustment uses the U.S. Producer Price Index for crude materials to inflate beginning inventory. In estimating this adjustment, the authors incorporated a weighting scheme to reflect the importance of the FIFO method in determining inventory value. The second accounting adjustment is to depreciation expense. The authors used a methodology that converts financial statement depreciation charges into an approximation of current-cost depreciation. This methodology requires an estimation of the average age of fixed assets and then grosses up their value to reflect inflation as measured by the GDP implicit price deflator for nonresidential fixed investment. This adjustment reflects how depreciation expense would change if it was based on the replacement cost of fixed assets rather than on their acquisition cost. The debt adjustment reflects inflation’s effect on the real value of creditor claims; GAAP-based earnings reported by leveraged companies will overstate the true cost of debt because they do not reflect the benefit that accrues to shareholders from being able to repay a fixed amount of principal with a currency that has been devalued by inflation. The authors used a company’s net debt position as the theoretically correct measure of debt and multiplied it by the expected rate of inflation to determine the debt adjustment. Data for the expected rate of inflation are the one-year-ahead inflation forecasts for the chain-weighted GDP price index from the Survey of Professional Forecasters (www.phil.frb.org/econ/spf/index.html). The authors used predictive regression models to test the importance of the accounting and debt adjustments as predictors of real returns. Their results show that the coefficient estimates for the adjustments are statistically significant over the period of the study. Thus, the recommended adjustments to GAAP-based reported earnings should be considered important by investors. The results are particularly robust for the debt adjustment because the coefficient estimate for that variable is statistically significant at the 1 percent level in all regressions. Over the period of the study, average real returns were highest for the quintile of companies with the highest debt-to-market-capitalization ratio. For those companies that increased their debt-to-market-capitalization ratio, the authors found that the quintile of companies with the greatest increase had the highest average real returns over the period of the study. The authors believe that their findings support the contention that debt usage should be viewed in a more favorable light by both investors and nonfinancial companies.