If I reported that Safeway (SWY) lost $4.06 per share last quarter, and if I gave no further explanation, the grocer’s stockholders might think me unfair. The loss stemmed from a large, one-time charge to reflect a decline in the value of two chains. No cash changed hands, and the loss had little to do with recent sales or expenses. Ignoring the change, Safeway turned a profit of 53 cents a share, meeting analysts’ expectations.

Safeway isn’t alone. Two-thirds of S&P 500 companies last quarter had special adjustments to earnings that caused operating earnings to exceed GAAP earnings, as they’re called. GAAP stands for generally accepted accounting principles—the rules by which U.S. companies must tally their earnings to satisfy government regulators. Operating earnings, however, are what Wall Street’s analysts forecast, which means they’re what the public uses when discussing whether companies are performing better or worse than expected.

The dual earnings system serves a purpose. “It’s difficult enough to predict quarterly widget sales and production costs,” says Howard Silverblatt, senior index analyst at Standard & Poor’s. “You wouldn’t want analysts guessing which financing decisions companies will make each quarter. Earnings estimates would be all over the place.”

However, the public focus on operating numbers might give some investors the impression that GAAP earnings are irrelevant. Over the long term, they’re telling. “Non-operating” charges often reflect operating decisions made in the past. Likewise, “non-cash” charges often adjust the balance sheet for money that changed hands in the past. On one hand, GAAP numbers sometimes tell a nonsensical story about one period’s results. On the other hand, operating earnings for that period might beautify results too much.

Unlike GAAP earnings, operating earnings have no formal definition. That gives companies leeway in the adjustments they mention in their press releases. As the chart below illustrates, as operating earnings have attracted more of the public’s attention over the years, the amount by which they exceed GAAP earnings has generally grown larger, too.

S&P 500 Earnings

To investors, this means price/earnings ratios for the broad market might mislead if they’re based on operating earnings. For example, U.S. stocks have traded at an average of just below 15 times trailing earnings over the past 138 years. During most of that stretch, investors didn’t adjust earnings for special events. So it’s not quite analogous to say that the S&P 500 trades now at 20 times trailing operating earnings, versus a long-term average for U.S. stocks of below 15. For that comparison, it’s better to say the index trades at 23 times GAAP earnings.

In fairness, those earnings might still be depressed because of the recent recession. Then again, the index trades at 14.3 times its GAAP profits reported in 2006, during the peak of the housing bubble, when consumers were spending frantically. In other words, the market is pricing in one heck of a recovery.

In the next issue of SmartMoney magazine (available mid-April) I’ll go into more detail about how stock pickers can protect themselves against the effects of earnings beautification on price/earnings ratios.

Jack Hough is an associate editor at SmartMoney.com and author of “Your Next Great Stock.”

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