Non-GAAP Earnings Aren't The Solution

by: Baruch Lev

Summary

The astonishing proliferation of non-GAAP earnings is a symptom, not a solution to GAAP's shortcomings.

But the drawbacks of non-GAAP earnings are serious.

In my new book (with Feng Gu), we propose a new information paradigm: The Resources & Consequences Report.

The astonishing proliferation of non-GAAP earnings - reported by 90% of S&P 500 companies, according to a recent Seeking Alpha article - is a symptom, not a solution to GAAP's shortcomings. It's a symptom of the widespread belief among corporate executives that GAAP earnings no longer reflect the real performance of businesses, particularly due to the adverse impact on reported earnings of one-time items (restructuring charges, asset write-offs, marked-to-market of financial assets/liabilities), and various unreliable estimates underlying earnings computation (goodwill write-offs, stock option expense). These are legitimate managerial and investor concerns.

The proliferation of one-time (transitory) items in the income statement is the result of the "balance sheet model" adopted by the FASB during the last two-three decades, emphasizing the periodic valuation of assets and liabilities (fair values) over the careful matching of revenues and expenses in the income statement. The main adverse consequence of the balance sheet model is that periodic assets/liabilities value changes (assets and goodwill write-offs, fair value changes of financial items) - largely random changes - are dumped on the income statement, increasing earnings volatility and adversely affecting the ability of earnings to predict enterprise performance, their main use by investors. Contrary to common beliefs, it's not easy for investors to "clean earnings" from these one-time items, since components of such items are often embedded in cost of sales and SG&A expenses. GAAP earnings, therefore, often misrepresent enterprise performance and fail to predict future earnings. Non-GAAP earnings, cleansed of certain one-time items, generally predict future non-GAAP and even GAAP earnings better than GAAP earnings. That's the logic underlying the proliferation of non-GAAP earnings.

To demonstrate this, I have computed for Gilead Sciences (NASDAQ:GILD), a large and successful biotech company, the correlation of current quarter earnings and same quarter earnings a year later - a measure of earnings ability to predict future earnings - over the years 2007-2012. The correlation for non-GAAP earnings is substantially higher than that of GAAP earnings - 0.69 vs. 0.49 - suggesting that the former predict earnings better than the latter, due to the deletion of certain transitory, one-time items from non-GAAP earnings.

But the drawbacks of non-GAAP earnings are serious. In particular, unlike their GAAP counterparts, the computation of non-GAAP earnings isn't comparable across companies - different companies add/subtract from GAAP earnings, different items - and this is often done in an inconsistent manner: same company changes deleted items from year to year. Analyzing comparable companies by non-GAAP earnings is, therefore, problematic. And the fact that non-GAAP earnings are always higher than GAAP ones, contributes to investors' suspicion and derision (Kool Aid and wishful thinking).

But the main problem with both the backward-looking GAAP, as well as non-GAAP earnings is that they rarely reflect the fast-changing fundamentals of the business, crucial for predicting future performance. In February 2016, for example, Tesla Motors (NASDAQ:TSLA) released quarterly earnings (actually a loss) which missed by a wide margin analysts' consensus, while at the same time reporting significant increases in vehicle production and delivery. Investors correctly ignored the earnings miss, as evidenced by the 4.7% share price increase upon the earnings announcement focusing on what matters - production and delivery. The arcane accounting system does not reflect fundamental business changes - decreases in new subscribers, or churn rate increases of Internet, telecom, and insurance companies, drugs approaching patent expiration of pharma and biotech companies, or oil & gas companies failing to replenish their reserves - and non-GAAP earnings aren't doing a better job of reflecting business reality. What's an investor to do?

In my new book (with Feng Gu), "The End of Accounting and the Path Forward for Investors and Managers," we propose a new information paradigm: The Resources & Consequences Report, which highlights the recent changes in the business fundamentals of companies, and we demonstrate this report with specificity for four major economic sectors: media and entertainment, insurance companies, pharma and biotech, and oil & gas enterprises. Our report focuses on the strategic assets of companies - the unique and difficult to imitate resources, such as patents, brands, business processes (like Amazon's (NASDAQ:AMZN) and Netflix's (NASDAQ:NFLX) customer recommendation algorithms), wireless spectrum, or airlines landing rights - which are the major value-drivers of companies, yet mostly missing from the balance sheet, despite the FASB's "balance sheet model." The Report highlights the investment in strategic resources, like customer acquisition costs, or employee training; their recent changes (deterioration of the customer franchise, for example); protection of these resources from infringement by competitors and disrupting new technologies (on-line sales); and the value created by deploying the resources. This fundamental, forward-looking information provides investors with a realistic view of the enterprise performance and a solid basis for predicting future growth, which conventional financial reports largely fail to do.

Our new disclosure paradigm directs investors to the information often available, albeit scattered, in the MD&A, earnings quarterly conference calls and accompanying materials, and other company presentations, and instructs them how to form from this information a comprehensive view of the firm's value-creating resources and management's success in the deployment of the resources. This new approach at investment analysis is a far cry from the conventional, accounting-based analysis, using the dated spread sheets. It focuses on value creation and future growth, which both GAAP and non-GAAP earnings often fail to highlight.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.