Determining earnings will always be fraught with estimates, even
if made in good faith. The bottom line is that cash flows, as well as divi-
dends, are much harder to manipulate than earnings.DOWNWARD BIASES IN EARNINGS
Although some accounting conventions work in a favorable direction
for the firm, there are many that work in the opposite direction. For ex-
ample, research and development costs are routinely expensed although
there is good reason to capitalize these expenditures and then depreciate
them over time.^23 This means that the earnings of firms with a high level
of R&D expenditures, such as the pharmaceutical industry, may be un-
derstating their earnings.
Take Pfizer, the largest drug stock in the world and one of the 10
largest companies in the S&P 500 in March 2007. In 2006, Pfizer spent
$7.6 billion on research and development for drugs and slightly over $2
billion on plants and equipment. Governed by current accounting rules,
Pfizer subtracted from its earnings only 5 percent of the $2 billion it
spent on plant and equipment as depreciation because the remainder
would be deducted over the useful life of these assets.
But 100 percent of the $7.6 billion Pfizer spent on research and de-
velopment was subtracted from its earnings. This is because Pfizer’s
R&D is not considered an asset under these accounting definitions, and
it must be expensed when the expenditures are made.
Does this make sense? Is Pfizer’s R&D less of an asset than its prop-
erty, plants, and equipment? Considering that Pfizer’s value largely
stems directly from the patents it gains through its research and devel-
opment expenditures, this accounting treatment seems to cast too nega-
tive a shadow on Pfizer’s performance.
Leonard Nakamura, an economist at the Federal Reserve Bank of
Philadelphia, believes this is the case. “It’s really those [R&D] expendi-
tures that are going to drive long-run corporate performance,” he has
stated.^24 Thus, in many ways, especially for industries with intensive re-
search and development, current earnings measures understate the fu-
ture earnings potential of the corporation and economic reality.
Another understatement comes from the treatment of interest ex-
pense. Interest expenses are deducted from corporate earnings evenCHAPTER 7 Stocks: Sources and Measures of Market Value 109
(^23) Leonard Nakamura, “Investing in Intangibles: Is a Trillion Dollars Missing from GDP?” Business
Review, Federal Reserve Bank of Philadelphia, Fourth Quarter 2001, pp. 27–37.
(^24) Cecily Kump, “Innovation,” Forbes, July 5, 2004.