Trust, But Verify: GAAP Versus Non-GAAP

| About: Express Scripts, (ESRX)

The Same, Yet Different.

It used to be simple. Companies reported earnings in accordance with GAAP (Generally Accepted Accounting Principles). Media sources published the news.

In recent years company managements and sell-side analysts have taken to adjusting GAAP data higher. Those better sounding profit numbers are called non-GAAP.

(Click to enlarge)

The non-standard measures of financial performance are far looser than GAAP numbers. Many times it is only these inflated results that are widely circulated by the press.

Financial website Investopedia said it this way:

"Many companies report non-GAAP earnings in addition to the required GAAP earnings stating that the alternate figure more accurately reflects their performance. Some common examples of non-GAAP earnings measures are cash earnings, operating earnings, EBITDA (earnings before interest, taxes, depreciation and amortization) and pro-forma income."

Companies would rather have analysts focus on higher "adjusted" EPS in order to make their stock valuations look cheaper. Restating EPS to carve out employee stock option expense obscures true compensation levels, including those of company officers.

(Click to enlarge)

Differences in reported data can arise from many sources. Other common adjustments come from merger-related expenses, revenue recognition decisions, any or all non-recurring items and even the decision about the most appropriate number of shares outstanding to be used in calculating EPS.

Managements must always disclose GAAP earnings. Often, however, they are buried in the footnotes of SEC reports and earnings call transcripts. Companies would rather have analysts focus on higher 'adjusted' EPS in order to make their stock valuations look cheaper.

On-line financial sites don't always disclose when they are not using GAAP figures. This can create huge differences in the reported P/E that various research services carry for the same stock.

Pharmacy benefits management firm Express Scripts (NASDAQ:ESRX) provides a prime example. Its shares closed at $62.98 on Monday, June 17, 2013. Here are the 'Analyst Estimates' sections for ESRX as shown on that date from Yahoo Finance, MSN Money and Value Line.

(Click to enlarge)

Yahoo used Non-GAAP estimates in showing 2013-2014 projections of $4.30 and $4.93, respectively. They did not mention, or even footnote, that these were not GAAP projections. Investors using those numbers came up with reasonably low P/E multiples of 14.7x and 12.8x for this year and in 2014 respectively.

MSN Money Central showed an almost identical set of estimates. Once again the current year and 2014 multiples look quite low for a high-quality, conservatively financed growth company.

(Click to enlarge)

Check out ESRX in Value Line and you see a very different set of estimates. Value Line's research used GAAP accounting in coming up with 2013 and 2014 expectations of $2.70 and $3.30. Based on those numbers this year's P/E is 23.3x and the 2014 multiple would be 19.1x.

(Click to enlarge)

Value Line noted that Express Scripts' management has said publicly that they expect to earn $2.80 /share in 2013 including any additional amortization charges from the 2012 purchase of Medco Health Solutions. It is mainly these non-cash charges that created the large discrepancy in reported EPS.

How would a typical investor know that? Which figures are correct? Does two-out-of-three count? Consulting MSN money would break the tie with estimates based strictly on non-GAAP, without mentioning that important fact.

Taking the time to read official company reports, with all their footnotes, will make you a better informed investor. Deciding if a stock is reasonably priced means comparing apples to apples. Don't get caught thinking a valuation is low by viewing adjusted EPS against previously reported GAAP data.

You would expect that well-regarded sources of financial data could be relied upon for accuracy. As always, it is safer to trust … but verify. Express Scripts is a large personal holding for me. Whichever way you choose to calculate its earnings, the company appears to offer solid growth prospects.

Disclosure: I am long ESRX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.