Games Wall Street Plays

With earnings season in full swing, the jargon is flying. Profits seem to come in 31 different flavors, depending on which accounting trick a company is scooping out, while analysts throw around arcane terms and follow each other like lemmings to upgrade or downgrade stocks after the quarterly reports come out.

Much of the confusion comes when you aren't privy to the rules of the games Wall Street likes to play. We've put together a guide to help you understand what the jargonauts of Wall Street are really saying.

Earnings obfuscation

Companies like to put their own spin on the profit numbers, excluding a one-time charge here or ignoring debt there. Enron boosted its earnings repeatedly by excluding charges that weren't on any income statement in the first place, says Stephen Rigo, a research analyst for Thomson First Call.

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When checking out profits, look for operating earnings -- that is, earnings derived from generally accepted accounting principles (GAAP).

Operating earnings are a company's revenues minus regular operating expenses. The rules on what's excluded are pretty strict and generally have to be nonrecurring expenses. And because operating expenses reflect a company's core dealings, they're generally stable year over year.

Zacks and Thomson Financial, which poll analysts on how much they expect a company to earn and compile consensus earnings estimates, report operating earnings. So if a company "beats the Street," the company's operating earnings exceed the consensus estimate.

But sometimes corporations play games with the numbers. It's not unusual for a company's CEO to appear on Squawk Box touting pro forma profits that will likely be better than Wall Street's expectations.

Pro forma is another way of saying "forward looking," so some guesswork goes into the calculations. Profits that are pro forma may exclude operational expenses that are one-time only or that have been incurred but not yet paid for, but companies can get creative. Take, for example, Amazon.com which reported its first profit in the fourth quarter of 2001. On a pro forma basis earnings were a robust 9 cents a share. But the net profit (which doesn't allow any exclusions) was just 1 cent a share.

Another term analysts and CEOs love to bat around is EBITDA (earnings before interest, taxes, depreciation and amortization, pronounced "ebb-ih-dah"). EBITDA is mostly used by fund managers, analysts and other Wall Street insiders as a way of measuring income to assign some type of valuation to a stock.

"If you think of revenue at the top of a company's balance sheet and net income at the bottom," Rigo says, "EBITDA sits somewhere in between." Basically, it's a measure of earnings that can't be manipulated, he says.

Ratings roulette

Remember Henry Blodgett, the former Merrill Lynch analyst who put an irrationally exuberant $400 price target on Amazon (AMZN) back when profitability for the company wasn't even a pipe dream? Shares are now trading at a more humble $35.

"Analysts have gotten beaten up for what happened," says Rigo, referring to the boosterism of analysts during the tech boom and the massive losses investors sustained during the tech bust. But they're being encouraged to be as honest and realistic as possible now, and the trend in ratings shows that they're coming around, he says.

Even though the trend is going in the right direction, investors should still be wary of conflicts of interest often found in the industry.

Analysts tend to shy away from being critical of the stocks they follow because the investment firms that employ them could have underwritten the security. And some analysts fear that if they raise the ire of a company they cover, it will withhold information from them.

One way to use analyst ratings is to lower them by a notch -- so a "strong buy" is really a "buy," a "buy" is really a "hold" and so on.

The real value of Wall Street research comes in the analysis of a company, its earnings potential and strength of its balance sheet and management. Take the ratings with a grain of salt.