Non-GAAP (Adjusted) figures vs GAAP figures

[SaulR80683]

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.

Saul

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:

1. 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…)

2. 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.

Saul

[brittlerock]

I was going to stay out of this discussion. In an earlier thread Denny accused someone of being “accounting impaired” which is pretty good description of me. I have no reason why. I’ve got a degree in math and I performed analytical work for the better part of my career, but there’s something about income statements, balance sheets and so forth that makes my eyes glaze over and mind go numb. But, with that caveat, here’s my impression of the great GAAP v. non-GAAP debate.

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. - Saul

I think the size and maturity of the company has a lot to do with it. I held Apple stock for a while, right around the time of their first stock split (any since?). As I recall they always reported GAAP. The great, big aerospace company I worked at for 30 years reported GAAP. I’ve not looked at the financial reports of the Dow Industrials, but my guess is they report GAAP. My point is that when a company gets to be in the hundreds of billion dollar range maybe non-GAAP just doesn’t give you that much more insight regarding the health and operation of the enterprise. And if there is a really big and unusual expense or windfall, they usually at least highlight it.

But that’s not the kind of companies in which we are invested. For companies at the maturity and size we typically invest in an unusual expense or windfall will make a very significant impact of the financial reports and distort year on year comparisons.

So for me anyway, for these investments I agree with Saul for all the reasons he succinctly pointed out as I struggle to stay awake when performing financial analysis.

[captainccs]

I was going to stay out of this discussion. In an earlier thread Denny accused someone of being “accounting impaired” which is pretty good description of me. I have no reason why.

First, Saul, thanks for the thread!

Accounting, like most everything else, one needs to learn, When I was selling accounting machines at NCR, my boss asked me if I knew accounting. “No.” He told me to learn the stuff, how else was I going to sell accounting machines? I enrolled in a university extension course by mail and soon accounting started to make perfect sense. I have been grateful ever since. Accounting has developed over the years from its start in Italy over five centuries ago. Initially it was used by owners to run their business and all was well. When the government introduced income taxes, accounting acquired a new role that had little to do with running the business, in fact, that created a conflict of interest, the government wanted to collect more and the business wanted to pay less. All the CRAP that FASB has been adding to accounting just creates more conflicts of interest and business fights back. That’s what the adjusted numbers are.

At first double entry book-keeping tends to be confusing until someone explains it. After that it make good sense. But accounting is not physics with universal laws, there are valid differences of opinion. After all, accounting has to make sense of complex business logic.

Denny Schlesinger

[5761796E65]

Saul, another great discussion. IMO, there is no right or wrong, just different ways the data can be analyzed. Just a few clarifications…

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.

This is the best case scenario, a one-time extraordinary event. Some companies tend to have more “one-time extraordinary events” than other companies. IMO, it is impossible to make any clear guidelines that would be interpreted equally across all companies.

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!!!

Just to be clear, GAAP earnings stay the same. GAAP EPS increase because there are less shares used in the calculation. And yes, it is broken that the EPS changes depending on the stock price. But ignoring in-the-money warrants and the eventual/potential dilution also distorts the big picture.

[Tamhas]

As I recall they always reported GAAP.

Reporting GAAP is required. Also reporting non-GAAP is optional, but indicated if GAAP does not give a good view of the actual company operations at the current time. If such conditions exist, you can bet that the company does its internal management on a non-GAAP basis … and as an investor, that’s what you should be using too.

[luciuse]

I think the answer to non-GAAP vs GAAP really has to be ‘it depends’

Truth is that current GAAP rules can cause huge distractions, depending on which industry you are in. Companies that own substantial stakes of other listed companies have to revalue that stake at market price each quarter, which can create overall earnings swings that dwarf their earnings from operations. Just look at Bio-Rad Laboratories. Markel, Berkshire are similar examples.

So in an ideal world, adjusted (i.e. non-GAAP) would be my preference, as it’s meant to give a clearer picture of operational results, that’s not distorted by one-time or non-operating items.

Alas, this is based on the assumption that non-GAAP earnings are presented in good faith, and too many companies can’t resist putting all the bad stuff into the ‘adjusted-out’ portion. Essentially, you can make non-GAAP whatever you’d like it to be because you are free to define what you want your rules to be.

So it takes a little bit of faith into the integrity of management to go with non-GAAP, and my recommendation would be to at least have a look at the reconciliation of GAAP to non-GAAP, in order to see all the bad things the company deemed of no interest to their shareholders. You may disagree…