Honest EPS: a measure of GAAP earnings relative to pro forma earnings

Purpose – This study empirically examines whether there is an anomalous factor return to a stock's Honest EPS. Design/methodology/approach – Honest EPS captures any large discrepancy between a company's primary earnings per share and the company's Pro-forma earnings per share, normalized by price. Pro-forma earnings issued in a company's press release have become a pejorative word to investors and the financial media alike. Findings – Honest EPS is rigorously tested for the top 1,000 largest market capitalization stocks and the broader top 3,000 largest market capitalization stocks from 1987 through 2002. It was rebalanced monthly, quarterly, semi-annually, and annually. We show a portfolio long the highest or top decile Honest EPS and short the most negative or bottom decile in which Honest EPS produced significant excess return with a commensurate high information ratio. Practical implications – Investors can use this simple formula for Honest EPS to identify companies that are abusing pro-forma quarterly reporting to inflate their earnings relative to primary earnings reported to the S.E.C. according to generally accepted accounting principles. Originality/value – An investor can choose to punish the worst Honest EPS companies by short selling their stock, reward the best Honest EPS companies by buying their stock long, or add this as a risk to be aware of in their stock selection.