The report, which measured 37 tech companies from 1997 to 2000, looked at earnings quality. Merrill Lynch analysts found that a variety of techniques, particularly stock option accounting, resulted in higher reported earnings for the companies studied. On the whole, reported earnings for 2000 were an average of 25 percent lower after the researchers eliminated nonoperating items and one-time charges, and determined the stock option expense.
"As a result, valuations are higher than investors think," analyst Steve Milunovich wrote in the report released Tuesday.
"Accounting for tech companies results in significant understatements in balance sheets and earnings statements," analyst Gary Schieneman said on a conference call. "Because of that there's severe limitations of the use you can make of financial statements. By far the most important (metric) is know-how."
Schieneman also pointed out that it is difficult to gauge how well companies' investments in their affiliates and alliance partners are doing because a company isn't required to list stakes of less than 20 percent in their financial statements.
"I believe a significant amount of future growth will be dependent on how successful these investments are," he said. "Investors are dealing with less than complete information."
The companies studied used the "intrinsic value" plan to account for their stock options, which does not require them to record an expense when they grant the options. By comparison, when a company gives compensation solely in cash, all of that money must be recorded as a payroll expense. That method is much more common in Europe, which may be one reason why U.S. companies appeared to be outperforming their European counterparts, Milunovich wrote.
If the companies studied had counted their stock options as an expense, the reported earnings of the group would have dropped by 60 percent. That figure excludes Yahoo, which would have reported an expense of $1.3 billion for options, reducing its reported earnings by 1,887 percent.
"Stock options are a big deal," Milunovich said on a conference call. "Perhaps companies wouldn't give as many options" if they had to take a 60 percent hit to earnings. "But they would have to pay at least somewhat higher compensation."
With the collapse of the tech boom, many of those options are now "underwater," where the exercise price is higher than the value of the option. But new accounting rules would require companies to record the options as an expense if they were simply repriced. In response, many companies have resorted to a variety of techniques, including the increasingly popular method of canceling existing options and granting new ones six months and one day later.
The best measurement of earnings quality, researchers found, is cash flow.
According to the report, a ratio of less than one when comparing cash flow to net income is a sign of deterioration in quality. Twelve companies studied had ratios of less than one, with the declines due mostly to a build-up in inventory and accounts receivable, which boost net income but do not affect operating cash flow.