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No one knows the real earnings of American corporations.

In Q1 2009, according to the Federal Reserve flow of funds table F.102, after-tax profits of US non-financial, non-farm corporations, on an annual basis, were about $589.9 billion.

However, about 50% of these after-tax earnings were disbursed through stock buybacks, primarily to support prices and give value to executive options. See: Stock buybacks refusing to die live on!

Understated cost of stock options

The “cost” of employee stock options, according to FAS Rule 123 of March 2004 must be “disclosed but not recognized” by issuers in their financial reports.

There is no easy way of knowing whether or by how much the earnings behind S&P price-earnings-per-share figures have been adjusted for executive stock options.

However, it is certain that, whatever the adjustment, it is far less than the cost to long-term shareholders in terms of cash no longer available for dividends or corporate reinvestment.

Investor monkeys contemplating the unknown.

FAS Rule 123 vastly understates the real cost of stock options

Legal market manipulation

Ever since 1982 when the US Securities and Exchange Commission granted “safe harbor” to corporations using stock buybacks to manipulate prices in order to give value to executive stock options, an increasing portion of corporate earnings have been diverted from dividends that would benefit ordinary shareholders to stock buybacks for the benefit of corporate executives.

While accountants argue technicalities as to whether the Black-Scholes model or the Binomial model best represents the “cost” of executive options that should be disclosed, the fact is that the true cost to shareholders is far greater than the actual benefit to executives, since it takes more money to manipulate prices upwards by using buybacks than executives actually receive as profits when exercising their options.

In other words, the buyback fraud lives on. See: The Great Misleading.

The stock buyback loophole

Money for dividends that would otherwise benefit long-term shareholders is diverted for manipulative purposes and is not registered as a cost at all, but, according to Generally Accepted Accounting Practices, is posted directly to the capital accounts of the company.

If buybacks were only a tiny portion of the market — as was the case in, say, 1980 — we might ignore this accounting foible.

However, in Q1 2009, despite the shortage of credit and the need to conserve cash to get through hard times, corporate executives, in general, supported by subservient boards of directors, continued to recklessly misuse stock holders funds to manipulate market prices for their own benefit through the use of buybacks. See: Stock Buybacks: A Simple Fable.

And the US SEC commissioners continue to avert their gaze from this shameful practice.

The S&P 500 price-earnings ratio

Is the real S&P 500 price-earnings ratio 18 or 36  — no one knows

If the S&P 500 PE ratio was 18, as now appears in the newspapers, one might conclude that stocks, although over-priced, were still a reasonable investment.

However, if the real PE ratio was closer to 36 — but hidden by the loopholes in GAAP, the current market “recovery” could be a mere bounce in a bear market heading for further losses — a suckers rally like 1932-1933 during the Great Depression.

It would seem that it is a little early to break out the champagne and to start celebrating economic recovery.

What do you think?