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How do investors know which stocks to buy and sell? Well, they get advice, they think, and they read. They read stuff (a euphemism) in the mainstream business press about different companies, and how they are doing, or not doing. Sometimes this "stuff" is informative. And sometimes it is not.

Case in point: consider some of last week's coverage of Salesforce.com (CRM). Salesforce released quarterly earnings last Thursday after the bell. The company reported actual, GAAP "earnings" of negative $.07 per share, and imaginary, non-GAAP "earnings" of $.42 per share. (Note to younger readers: "negative earnings" used to be known as "losses.") Non-GAAP "earnings," are numbers contrived by taking out whatever you want to take out of the real earnings, to arrive at the new, better-looking non-GAAP "earnings." In the case of Salesforce, the number they like to take out is their large option expense. Various articles, including my own, have questioned Salesforce's earnings, specifically the company's habitual practice of emphasizing non-GAAP earnings over GAAP earnings.

While it is understandable that a company like Salesforce, without earnings, or with negative "earnings," would choose to accentuate the positive, what is more difficult to understand is why anyone in the business press would choose to go along with this game, of even reporting the company's self-serving non-GAAP "earnings." It is even less understandable why a mainstream business press story would omit the company's real, GAAP earnings. It is even less understandable why a mainstream business press outlet would misidentify the company's imaginary, non-GAAP earnings as real earnings, as simply "earnings." And yet, at least two such stories appeared in the business press last Thursday, just prior to and after Salesforce's earnings release. The first was an article in TheStreet, which contained the following sentence:

He [an analyst] also increased his second-quarter earnings estimates, and now expects earnings of 40 cents per share on $731.6 million in revenue.

The second story appeared in Forbes, and contained the following sentence:

It [Salesforce stock] currently trades at 8.35 times sales and 73.75 times forward earnings.

Both of these stories were referring to imaginary, non-GAAP "earnings."

Others can troll through the media dreck surrounding the Salesforce earnings release and come up with more examples of mainstream business press stories (that term is chosen intentionally) using the term "earnings" in reference to imaginary, non-GAAP numbers; I haven't the stomach. But a question remains: why would business reporters report non-GAAP numbers as though they were GAAP numbers?

One explanation is laziness: The reporters simply regurgitate whatever mush the analysts spoon-feed them. Another possible explanation is ignorance -- the reporters, despite being employed as business reporters, don't know the difference between GAAP earnings and non-GAAP earnings, or that there is a difference. They may have been absent that day or week or year in business school when the professor covered the difference between GAAP and non-GAAP earnings.

I posit a possible third reason -- the reporters do know that there is a difference between GAAP and non-GAAP numbers, but they do not think it makes a difference to investors. But the difference between GAAP and non-GAAP numbers is important to investors. To explain why the difference between GAAP and non-GAAP earnings is important to investors, allow me to submit the following analogy:

Suppose that your spouse is a traveling salesman, or saleswoman, and you are the stay-at-home parent, raising the children. Your spouse gets an expense account, out of which they pay all their needs, food, shelter, cell phone, etc., lavishly. Their expense account comes off the top. It is a component of gross sales, essentially everything that remains after other expenses. Your husband or wife's expense account spending is not closely scrutinized as long as sales are going up. You, on the other hand, have to rely on net income.

So, when your husband or wife comes home from a road trip you say "Where is the paycheck? How much is it? We're broke!" Your spouse answers, "Don't worry! I had an AWESOME, BLOWOUT quarter with a huge REVENUE RUN RATE! I've been eating like a king for the past three weeks in the most expensive restaurants in this quadrant of the universe, and I took a Hummer limo from the airport home! We're doing great!" "We are?" you say, "The kids are hungry! We're behind on our rent!"

This encapsulates the difference between the interests of management and the interests of shareholders in a profitless company like Salesforce. Management is doing great. Management at Salesforce is being compensated handsomely. In fact, their stock-option compensation is arguably the main reason the company is profitless, as illustrated in my linked article.

To management, all is well. Just look at that revenue run rate! (Also known as "gross income.") If it hadn't been for all those headwinds (formerly known as "expenses,") why, the quarter would have been even more successful! But the stock of a company without earnings is bound to fall, eventually, as it is simply a hot potato for mo-mo investors, also known as speculators, operating on the greater-fool theory.

I hope that this analogy is simple enough for all to understand. A company that keeps some of its gross income as profit is a company that is being run for the benefit of shareholders. A company that spends so much of its income on compensation for management that it doesn't even make a profit is a company that is being run for the benefit of management, not shareholders.

End note: I tried to be fair and balanced when writing this, and consider the other side of the argument, and present it to readers, so that they could make up their own minds. Only there isn't another side. There is no excuse for business reporters to omit information as fundamental and momentous as the wildly-divergent GAAP and non-GAAP numbers of Salesforce when said reporters write stories about Salesforce's "earnings."

Source: Remedial Math For Business Reporters Covering Salesforce.com