Adjusting for Swings With Constant Currencies

Q2 earnings season is in full swing, and there is a new buzzword in town: constant-currency. As in, Widgets “R” Us reports earnings grew 4%, or 7% on a constant-currency basis. What is this, and what should we make of it? Read on.

Simply, constant-currency earnings aim to strip out skew from big currency swings in order to zero in on how the core business is faring. As you have no doubt seen headlines railing about, the dollar is near an all-time high relative to a broad basket of currencies, which has implications globally. When the dollar strengthens, it can hurt US companies’ overseas sales. If they don’t raise prices and transaction volumes stay constant, their revenue in dollars drops—the same amount of sales in euros, pounds or yen converts to fewer dollars. Or, if US companies raise prices in hopes of keeping dollar-denominated revenues firm, they risk losing market share. This dilemma often gets at least a partial offset from overseas costs being cheaper when the dollar is strong, but it isn’t always a wash. This is why you will have seen oodles of American companies blaming the strong dollar for disappointing earnings—and oodles of articles arguing it is a huge problem markets are egregiously ignoring.

Meanwhile, companies based abroad have the opposite problem. When their home currencies are weak relative to the dollar, they have to pay more in their local currency for parts, labor and energy sourced overseas and priced in dollars. They can get an offset from overseas sales, though. If they want to, they can cut prices overseas to gain market share without taking a big hit once they reconvert to totals to their own currency. Or, they can keep prices overseas steady and earn big fat profits from currency conversion.

Or, we should say, paper profits. In many cases, overseas revenues don’t get converted back to a multinational company’s home currency. Rather, the company will plow those back into whatever business they are conducting in that territory. So, Widgets “R” Us will take the euros it earns from selling widgets in the eurozone and use them to pay workers there, cover overhead costs and purchase parts and raw materials. But the rules and niceties of corporate accounting don’t let the CFO stand in front of investors and announce that profits in their eurozone business grew 6%, their UK business grew 8%, their Japanese business grew 5% and leave it there—they need a headline total. And if they are an American company whose shares trade on the US exchange and are priced in dollars, then that headline total needs to be in dollars. So, Generally Accepted Accounting Principles (GAAP) require companies to convert all overseas costs and revenues to dollars at the actual exchange rate. Similar practices overseas lead eurozone firms to convert everything to euros, British firms to pounds, Japanese companies to yen, etc.

As you can imagine, this can cause big skew when the dollar is on the move, bringing large fluctuations in earnings growth rates that may or may not match the actual results overseas. Pretend that Widgets “R” Us had total Japanese sales of ¥5 billion in Q2 2021 and ¥6 billion in Q2 2022. That shakes out to a 20% y/y growth rate. But in Q2 2021, ¥5 billion translated to $45.05 million. Q2 2022’s ¥6 billion, due to the yen’s depreciation to multi-decade lows relative to the dollar, converted to just $44.17 million. So, after conversion, a 20% sales growth rate morphs to a -1.95% sales decline. The 20% growth rate is far more meaningful to the core business, but accounting rules emphasize the slight decline.

Enter constant-currency earnings, which companies are increasingly reporting as a supplement to headline GAAP earnings. Note: They are a companion, not a replacement, and not all companies report them yet. Instead of using market exchange rates, companies will apply a fixed exchange rate to each currency. It may be last year’s or last quarter’s rate. This gives investors a dollar-based figure so they can see, in one number, how all the global plusses and minuses even out. But it does so without injecting wild swings from factors outside companies’ control. In concert with GAAP earnings and revenues, constant-currency figures can give investors a clearer look at how much currency fluctuations drew the bottom line away from the actual results on the ground.

We think headline and constant-currency figures are best used together—this isn’t an argument to throw away headline results and look at constant-currency numbers only. Rather, constant-currency figures give you more context with which to evaluate the headline results. These days, currency swings are artificially hurting several US multinationals’ results. But currencies move down as well as up, and there will come a time when the dollar’s moves make US firms’ bottom lines look better than they would on a constant-currency basis. Sniffing that out is also quite helpful.

Looking at constant-currency figures can also help you put headlines in context. These days, headlines cite the dollar as a big risk to the stock market as a whole. Constant-currency earnings can help you see through that, especially once you understand how companies actually manage their international finances. After all, if revenues in pounds, yen and euros aren’t actually converted to dollars in real life, then is it an actual financial hit when companies apply a conversion rate for accounting purposes? They also help you see past the myopia of short-term currency movements to help you see the business’s underlying fundamentals. These days, constant-currency earnings show that for all the handwringing, US multinationals’ overseas business is going pretty fine overall, a powerful counterpoint to investors’ latest fear.