Here are my thoughts on adjusted earnings (Taken from the Knowledgeable). I suggest you read through this carefully. There is a reason that:
Almost every CFO says in the Conference Call, “From now on I will be discussing only non-GAAP figures unless otherwise stated” and
Almost every company management says that they use the non-GAAP figures internally to evaluate the company’s progress, and
Every analyst (or almost every, in case there’s one out there somewhere who doesn’t), gives his earnings predictions in non-GAAP figures.
I use adjusted results because they tell you what the real company is doing. I pay no attention to GAAP earnings and only look at non-GAAP or adjusted earnings. I know this bothers some people, but it’s what I do. I feel that GAAP earnings ridiculously distort the picture…
Consider company X that has a big tax benefit this quarter and reports huge GAAP earnings, and then next year they pay normal taxes and looking at GAAP it appears as if their earnings have tanked, just for a trivial example.
Or company Y that has outstanding warrants. If their stock price goes down, GAAP rules makes their apparent GAAP earnings go up due to repricing of warrants. Just nonsense.
I especially remove stock-based compensation as an expense. I ignore the stock-based compensation first of all because it costs the company zero, it just dilutes the shares, and secondly because is already accounted for in diluted shares. More shares reduces earnings per share. Taking it also as a non-cash expense double counts it, which is why almost every company that I know of subtracts out the stock based compensation non-cash expense when they figure adjusted earnings or “real earnings.”
I don’t like excessive stock compensation either, but you have to remember that at most small technology companies, that is most of executive compensation, as the companies don’t have much money. It also allies the insider’s interests with ours if they have options that are only valuable if the price goes up.
In the earnings press releases, management almost always gives a reconciliation between adjusted and GAAP figures. You can see exactly what they leave in and take out so you aren’t taking it on blind trust. If I have confidence in management, I just use the adjusted earnings they give. If I start messing around and adding and subtracting things I won’t remember next time what I did and why, and also the earnings won’t be comparable with past and future earnings. On the rare occasions that I do eliminate something (a big swing due to foreign exchange gains or losses, for instance), I make a big note in red in my notes so I’ll remember to eliminate the same thing next time.
This perhaps sounds overly trusting, but what I’m aiming for is seeing how the company has been functioning over time, and accepting management’s adjusted earnings usually works for me. After all, they are trying to evaluate the same thing.
It’s important that you realize just how insane some GAAP rules are. Let’s consider company ABC, which makes engines, and has some outstanding warrants. What would happen if some terrible news came out during the next quarter? For example, if a big new engine had a bunch of defects, or a new competing product showed up which was taking lots of their customers. Their revenue would drop like a rock, and their stock price would crash (for good reason!).
GAAP rules for repricing the warrants would mean that because the stock price plummeted, the company would show huge (imaginary) INCREASES in GAAP earnings for the quarter!!! And this is from a system that is supposed to be giving the public a clearer idea about what is really happening at the company!
For those who wonder what their rationale is, it is this… stock price down = obligation from warrants reduced = more GAAP “profit”. If that makes sense to you, you are welcome to it.
By the way, analyst earning estimates are almost always adjusted earnings too, as far as I can tell. Also the companies’ disclaimers almost always specify that they use adjusted earnings for their own internal evaluations of how the company is doing. They often give GAAP results as a formality, and then base their entire discussion of results on adjusted results.
For those who think that GAAP are the only valid earnings, and that Non-GAAP are just “cheating,” these were the latest PSIX results, at the time I wrote this (which was sometime in 2014 or 2015):
GAAP earnings: 68 cents
Adjusted earnings: 39 cents
WHOA! Adjusted earnings only about half of GAAP?.. It’s supposed to be the other way around! How can that be? Because, as usual, GAAP has a lot of nonsense in it:
GAAP was up because the stock price was down so they had to reevaluate the “liability” of the warrants downward due to the lower stock price. This gave more GAAP “earnings”. (Note that if the stock price had been up, repricing of the warrants for more liability would give lower earnings. If you think that makes sense, well…)
In addition, GAAP income included a non-cash gain resulting from a decrease in the estimated fair value of the “contingent consideration liability” recorded in connection with an acquisition. This also gave more GAAP earnings.
Now if you think GAAP gives a better idea of how the actual business did in the quarter, be my guest. As I said, it’s nonsense to me.