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How Investors Should Navigate the Non-GAAP Earnings Confusion

16th June, 2016 · Adam Schwab, CFA, CFP
Adam Schwab, CFA, CFP

An Introduction and Three Guiding Principles

There has been a recent surge in the controversy surrounding non-GAAP earnings. While the debate continues on the proper use of non-GAAP metrics, investors can’t expect outside help and need to take control of their own understanding and interpretation of non-GAAP adjustments. Investors can’t rely on “guidance” from companies or regulators.

The problems run deeper than the GAAP vs. non-GAAP debate. The actual problem is investor’s lack of commitment to a thorough, fundamental understanding of the company. Without adequate understanding, investors will never be able to tell non-GAAP truth from fiction.  There is never a hard and fast set of rules to determine the validity of GAAP exceptions. Like any set of standards, there are exceptions and situations that don’t fit the model. The extreme doubters of GAAP or non-GAAP miss the point: no system is perfect. It’s the investor’s responsibility to determine the best representation of economic reality. Blind devotion to SEC guidance, FASB standards, or company management is a dangerous path.

This series of articles will help guide investors into asking the right questions involving non-GAAP metrics. This advice cannot replace actual analysis, but will give investors a better framework for thinking about these issues.

3 Rules to Remember

  1. Always reconcile each adjustment using the GAAP to non-GAAP reconciliation

Regardless of a company’s adjustments, investors should always reconcile to GAAP earnings. This figure, required by the SEC, allows investors to see a clean breakdown of non-GAAP adjustments. Unfortunately, that’s the easy part. The hard part is understanding what items are legitimate and which are not. Analyze every line item on an individual basis to determine its validity. One or two adjustments account for most of the deviations from GAAP. Unfortunately, there are no clear cut answers on which expenses are legitimate and which are egregious. Materiality depends on the company and industry dynamics. The only way to know is to dive deep into the business and financial statements.

  1. Pull up and compare reconciliations for the past 5 years

Don’t limit your analysis to the current year. Compare what “recurring”, non-recurring expenses have been consistent over many years. Repeated appearance is clear evidence that these charges are recurring in nature, even as management argues “one-off” or too volatile/unpredictable. In fact, a quick glance at successive reconciliations should show no yearly correlations between line items. Also, understand that the absence of repeated charges doesn’t mean one-time charges are legitimate. Evaluate every adjustment on its own merit.

  1. Match the reconciliation to the business model

Serial acquirers should not have their acquisition-related charges excluded. Acquisitions are part of their strategy and the associated expenses are legitimate and recurring. Major problems develop when analysts and management teams guide to high top and bottom line growth without the necessary acquisition spending to support that growth. It’s unfortunate that overconfident/aggressive companies and investors permit this mismatch to make valuation, free cash flow, and EPS more impressive. Some quick investor math on the implied ROICs would show an unsustainable level of ROIC into the future.

Look for Part 2 of this series next week on Freezing Assets.

Adam Schwab, CFA, CPA is a partner and portfolio manager at Elgethun Capital Management. Contact Adam at aschwab@elgethuncapital.com. Visit adamdschwab.com for more investing articles and podcasts.            

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Posted in Hot Topic Commentary, Local Charterholders | Tags: Adam Schwab, CFA, CPA, Elgethun Capital Management, non-GAAP earnings, SEC |
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