While analysts hail “the best earnings season in 13 years,” the market has delivered a solidly lackluster response. Over the past month, the S&P 500 is down roughly 1% despite a string of earnings beats.

With valuations this stretched, the market no longer appears willing to reward companies merely for beating quarterly expectations. Perhaps more investors now understand that GAAP net income numbers omit valuable information. They include non-operating items, are subject to manipulation, and don’t account for the cost of capital.

GAAP earnings don’t drive valuation. What investors should focus on are economic earnings, which make adjustments to exclude non-operating items and account for all sources of capital, both on and off the balance sheet.

Our analysis of the latest 10-K and 10-Q filings for the S&P 500 shows that the GAAP earnings growth in the market has not translated to an increase in economic earnings.

Figure 1: GAAP Earnings Offer Misleading Trend in Profits

Sources: New Constructs, LLC and company filings.

Through the first two quarters of 2017, GAAP earnings are up $61 billion from their 2016 levels, while economic earnings have declined by $28 billion.

Figure 2 shows the source of the discrepancy between GAAP and economic earnings comes mostly from invested capital growth that has outpaced growth in NOPAT. Companies are generating more operating profits, but they require an ever-larger invested capital base to do so. In other words, companies are growing their balance sheets faster than they are growing profits.

Figure 2: Trends In Net Operating Profit After Tax & Invested Capital For The Broader Market

Sources: New Constructs, LLC and company filings.

Figure 3 expands upon the trend shown in Figure 2. Companies are earning more profit for each dollar of revenue, but they’re also having to invest more capital to earn that revenue. When investors such as Jeremy Grantham argue that margins are higher today than in the past, they miss the balance sheet side of the story. Declining capital turns more than offset the rise in margins.