GAAP vs non-GAAP

Investment Analysis Clubs Saul’s Investing Discussions
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Just looked at the SSNI results:

Which gives a more consistent and useful picture?

GAAP Revenue of 122 up from 77 million
non Gaap: Revenue of 72 up from 69

GAAP: Gross Margin 53% up from 26%
non-GAAP: Gross Margin 46% up from 42%

GAAP: Net Income 26 million up from a loss of 16 million !!!
non-GAAP: Net Income 46% up from 42%

GAAP: EPS 50 cents up from a loss of 32 cents!!!
non-GAAP: 2 cents, flat with 2 cents.

GAAP so distorts it you might as well just toss them.

Sorry for belaboring a point but I see this so often.

Saul

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Saul, ewt. al-

I have watched analysis and discussion here and elsewhere regarding this topic. I agree that non-GAAP provides a window into company financials that is many times different than GAAP…usually in a useful way for analyzing whether to invest.

Ironically, there have been several articles such as this one in the WSJ
http://www.wsj.com/articles/sec-scrutinizing-use-of-non-gaap…

That appear to be regulators airing “concerns”. Is it because they feel that they must protect us from the predatory accounting practices that they feel might “rip us off?” I guess there must be a questions about free speech in financial reports? or is it something else?

Gary

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And here is a snippet from the Q&A portion of their (SSNI) conference call which also goes to Saul’s point.

Matt Robison (analyst)

Yes. I apologize I had to jump on late. So if you already answered this one, I’ll just get back in queue. But I was curious if you could explain a little bit about the 77% increase in recurring revenue per endpoint. You have nice increase in managed services and SaaS, but nothing like that. So if you could comment on what drove that and why it’s – grew so much more than managed services and SaaS?

Ken Gianella (SSNI Interim CFO)

Yes. I think that’s a GAAP number you’re giving. Non-GAAP, it was a 15% increase year-on-year for the non-GAAP metric.

Actually, I grapple with this quite a bit.
I struggle when Non-GAAP is much higher than GAAP. SNCR is a good example I can think of off-hand. Generally this is due to stock based compensation which is a real cost (I think). If Buffett thinks it is a real cost, I have a tough time disagreeing with him. This doesn’t necessarily mean the stock price will be negatively affected. In fact, Saul recently posted the tremendous results of companies with very high stock based compensation compared to those with very little.

On the other hand, I like it when non-GAAP more accurately reflects how the company is doing versus what GAAP would tell us. This gives me more faith in management. They aren’t just using non-GAAP to paint a rosy picture. It is being used to tell the real story.

And that, I think, is the crux of the GAAP v non-GAAP court case. Isn’t it ultimately how you feel about management and the numbers they report? Have you grown to trust them over time? Are their non-GAAP numbers truly used to give further insight into the business? Or are they used for ulterior motives?

But with the majority of companies I follow, generally non-GAAP is overstated due to stock based compensation. Even if those with vast stock based compensation show higher returns, it is still a tough concept for me to get on board with.

Take care,
A.J.

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But with the majority of companies I follow, generally non-GAAP is overstated due to stock based compensation.

That’s why it’s important to look past the earnings figure and read the full report and the conference calls - looking for things like tax deductions, the difference between diluted and non-diluted EPS and more generally what went on during the quarter. And beyond that as well - you may find that the company has been adjusting the revenues for “one time” legal proceedings in the last 6 quarters for example…

This is also why it’s hard (if not impossible) to automate Saul’s approach - it’s not just the metrics themselves, you need develop an understanding for what the company and its management is doing.

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Hi Phoolio,

How can anyone really take an accounting system (GAAP) seriously when it gives results like saying that this year Gross Margin is 53%, up from 26% the year before? When the real Gross Margins are 46%, up from 42%? Or EPS this year is 50 cents, up from a LOSS of 32 cents the year before? Doesn’t anyone on-high look at that and say “Whoa! Maybe there is something wrong with our GAAP system that needs to be fixed”? It astounds me.

As far as stock based compensation: Take company ABC with 1.0 million shares of stock and $1.0 million in profit this year. They already put it in the bank. So they made $1.00 per share. Let’s say they have a PE of 20. Nice normal PE. So the stock is selling for $20 per share. With me so far?

Their CEO has done a great job for three years running and they decide to give him a bonus in stock. They give him 50 thousand shares of stock worth $1.0 million. Did they now make zero for the year? Then how do you explain that million dollars profit that’s sitting in the bank? NO! They made $1.0 million, just like before, but now, instead of a million shares, they have 1,050,000 share, because there are 50 thousand more shares! So their earnings drop from $1.00 a share to 95.2 cents per share ($1.00 million divided by 1.05 million shares). If they keep their 20x PE, the stock price would fall to $19.04 due to the dilution which reduces the EPS, but they sure as heck still made that million dollars which is STILL in their bank account. How can you see it any other way.

Stock based compensation dilutes the number of shares but it doesn’t make the profit go away, and GAAP saying it does is just a punishing parent saying “You bad boys, pay it in stock and we’ll punish you by counting it twice, once in dilution, and again by making believe it reduces earnings too”!

Best,

Saul

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I guess I’m dense, but I don’t see how you can take an accounting system (non-GAAP) seriously where a company gives the entire million dollar profit to its CEO, but because they use stock it’s only a nickel a share and they are still making a profit with a PE of 19.

In the end there is no profit accruing to the shareholders/owners. It’s a con game relying on the greater fool principle.

GAAP has its faults and could use an overhaul, but a company such as you described should be avoided for investment purposes.

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I don’t see how you can take an accounting system (non-GAAP) seriously where a company gives the entire million dollar profit to its CEO

They don’t give him any profit. They give him a portion of your share.

It’s a con game relying on the greater fool principle.
How is this a con if they tell you what they are doing? Diluted EPS is a standard measure in every report! You need to be able to read and understand financial statements if you want to invest in individual stock - regardles of whether you prefer GAAP or adjusted figures. It’s only a greater fool principle if you approach it foolishly.

Look at it this way: If you don’t like companies giving away a percentage of your share, you should avoid them. The only way to avoid them is to understand the qarterly reports. To understand the reports you need to understand either what are all the things that went into GAAP or what was removed in non-GAAP - does not really make that much difference…

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I guess I’m dense, but I don’t see how you can take an accounting system (non-GAAP) seriously where a company gives the entire million dollar profit to its CEO

Hi King, Maybe you didn’t read the example I gave. They didn’t give any of the profit away. It’s still in the bank. They diluted the stock by 50 thousand shares. Now I don’t like having my stock diluted excessively either, but that doesn’t mean they gave away any of the profit. As I said, it’s still in the bank.

Here’s proof for you! If the board said let’s give away all of this year’s profit that we have sitting in the bank as a special one-time dividend, you’d get 95.2 cents dividend on each of your shares. It can’t be any plainer than that.

I hope that helps!

Saul

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How is this a con if they tell you what they are doing?

They may tell you what they are doing, but somehow it doesn’t register as being so bad when companies give away stock instead of cash.

Here’s another way of thinking about it that may make the expense seem real.

Imagine that in Saul’s example you own all 1 Million shares, worth $20M, the market cap of the company.

After giving the CEO his 50,000 shares how much are your shares worth?

The company is still worth the same, so your shares are now worth

(20,000,000 / 20,050,000) X 1,000,000 = 19,047,619

You’ve just lost $952,381!

The CEO’s gain is the same.

This is a very real transfer of wealth from the shareholders to the CEO.

And yes, you did give away most of the $1M profit that the business just made.

Ian

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And here’s a classic example of management taking for suckers anyone who looks only at non-GAAP:

http://discussion.fool.com/this-is-a-classic-example-of-how-mana…

If you think this accurately presents the company’s results, or that it’s an isolated incident, I’ve got some beautiful beachfront property in Kansas to sell you.

Fletch

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Saul,

I’m a little confused still. You say that stock comp expense only results in dilution and not a hit to earnings, but usually, stock comp expense is only booked if the exercise price is lower than current market price.

So in your example, the dilution of 50,000 shares occur, but the $1m expense would only be booked if the options were issued at $20 per share under current market value. So let’s say the stock is currently $30 a share, well the CEO can exercise his 50k lot at $10 a share, then that $20/sh or $1,000,000 has to come from somewhere, right?

Am I misunderstanding how stock comp expense is calculated?

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Correction

(20,000,000 / 20,050,000) X 1,000,000 = 19,047,619

should be

(20,000,000 / 20,050,000) X 20,000,000 = 19,047,619

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Stenlis,
I agree pretty much with everything you say. We do need to understand what adjustments to GAAP are being done to produce the non-GAAP numbers and invest accordingly.

Con game is probably the wrong term. As you point out, they do tell you their diluted EPS. Pyramid or Ponzi scheme is a better description.

Money is fungible so we can say his million dollars comes from anywhere we like but it has to be accounted for. It’s clearly an expense representing compensation, but it’s a deferred expense and should be accounted for in that manner.

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This is a very real transfer of wealth from the shareholders to the CEO.

Hi Ian, what you describe is a very real dilution of the shareholders, which gives a new shareholder part of what the old shareholders used to have. That’s what dilution means! But it doesn’t affect the profit that the COMPANY made. You have a right to be angry that the company gave away 5% of what you would have had. But the abstract COMPANY doesn’t know or care who its shareholders are, or how many they are, or how they are divided up. The COMPANY just knows that IT made a million dollars, and that money is in the bank, and on its balance sheet as Cash. Your particular share of it, as a prior shareholder, may be 5% less than it would have been, but the abstract COMPANY couldn’t care less.

Think about it! Being justifiably angry that they diluted you doesn’t change the fact that your share of the profit may be less, but the COMPANY’S profit isn’t affected.

Please tell me that you see this. :wink:

Saul

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Or, rather

(20,000,000 / 1,050,000) X 1,000,000 = 19,047,619

Market cap / shares outstanding = share price x number of shares = value of holding after the grant.

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Please tell me that you see this. :wink:

Yes Saul, in the scenario that you outlined, the company has banked $1M in cash as a result of its operations, and if you ignore what is going on with the ownership of the company then you could regard that as a $1m profit made by the ‘abstract’ company.

And there’s absolutely nothing wrong with thinking about it like this, if that’s what makes most sense to you.

I like to think about it in a different way.

Let’s imagine that the CEO got paid his $1m in cash, and then the company went out to raise the cash by selling $1m of shares.

The CEO decides he’d like some shares and takes the whole $1M paying for them in cash.

The end result is the same.

The $1M is in the bank, the CEO has his shares, and the overall share count is the same.

But in the second scenario the reported profit is zero. But to all intents and purposes the transactions are equivalent to the first scenario. The only difference is where you put the accounting entries.

That is why I like to think about stock based compensation as an expense.

But that’s just my preference.

I think the most important thing is that when you read the reports it doesn’t matter whether you start with GAAP and look at the adjustments or look at non-GAAP and see how it reconciles back to GAAP.

As long as we make sure that we know what the adjustments are and why management thinks that making those adjustments are a good idea.

It’s easy to get tied up in semantics, but it doesn’t really get us anywhere. If we are taking a hit as shareholders, does it really matter whether we are getting hit by dilution or getting hit by a wage expense? The hit is just as painful either way.

We may be taking two different roads, but I think we will both end up in the same place.

Ian

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“It’s easy to get tied up in semantics, but it doesn’t really get us anywhere. If we are taking a hit as shareholders, does it really matter whether we are getting hit by dilution or getting hit by a wage expense? The hit is just as painful either way.”

Ian, I think you and Saul are coming about this with completely different perspectives

You are positing that THIS YEAR’s earnings are zero, that’s absolutely true from an economic perspective

Saul is saying that the best way to evaluate a company’s continuing prospects is to calculate an ADJUSTED look at a company’s annual earning power

IF you think the CEO will be paid $1m in stock every single year, then yes, your way of thinking would be correct

Saul is thinking that it’s a one time hit and not likely to repeat with regularity in the future

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Ian, I think you and Saul are coming about this with completely different perspectives

I don’t think it makes much difference whether it is a one-off or a recurring expense.

Our perspectives are not so different. I can fully understand why Saul looks at it his way - it does make some kind of sense.

As long as you know in your own mind what you are doing and why, it doesn’t really matter.

It’s making sure you understand what is going on that is important. One way or another stock based compensation is a hit to the shareholder - how you think about it is a matter of preference.

Ian

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I don’t think it makes much difference whether it is a one-off or a recurring expense

I think the bigger question is whether or not it is an expense.

Saul clearly believes it is not an expense. An expense would cause less profit in a quarter. Saul doesn’t believe profit is affected at all with stock based compensation. The only thing affected is share count. So it affects EPS, but not actual profit dollars.

So which is it? Is it an expense or not?

Thanks,
A.J.

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If you pay all your employees in stock, profits would apparently rise.
If you can get your suppliers to accept stock as payment, profits would skyrocket.
Is that where accounting is headed?

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