[11/14/19] Should You Ignore Non-GAAP Earnings?

You surely heard about WeWork—the real estate company providing shared workspaces—and its founder Adam Neumann’s misfortunes: IPO’s cancellation and in Neumann’s case—dismissal. Prominent among WeWork’s information disclosures raising the SEC’s and investors’ concerns was a non-GAAP earnings measure WeWork called “community-adjusted Ebitda” which magically flipped the company’s 2018 $1.9 billion GAAP loss to a $467 million profit, by eliminating from Ebitda (earnings before interest, taxes, depreciation and amortization) various expense items.[1]

Such information wizardry gives a bad name to non-GAAP earnings, which 97%! of S&P 500 companies now report routinely, alongside, of course, GAAP (the official accounting-based) earnings. Various financial analysts and the media continuously criticize non-GAAP earnings as, at best, wishful thinking, and, at worst, a sham and fraud. Thus, for example, the Journal on October 18, 2019, reported on a study claiming that reliance on non-GAAP earnings makes it harder for investors to forecast firm performance. The study shows that, on average, non-GAAP earnings were 15% higher than GAAP earnings, and that analysts sometime misinterpret the meaning of non-GAAP earnings.

So, here we are. A full 97% of S&P 500 companies report non-GAAP earnings and other unofficial performance measures, but the practice is nevertheless widely criticized and even derided (someone said: the best non-GAAP earnings is EBE—earnings before expenses). So, what’s an investor to do? Here is my take:

The main question is missed in the continuous debate about non-GAAP earnings: how did we get to a situation where practically all the important U.S. companies are routinely reporting non-GAAP earnings? Just 15-20 years ago hardly any company reported such numbers. What happened during the past two decades? Look at the following figure and you will understand what happened.[2]

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The figure shows the dramatic decline in the usefulness of GAAP earnings—those earnings that critics of non-GAAP data believe are perfect indicators of enterprise performance. How wrong!

The figure reflects the gains investors could have had from a perfect prediction of earnings. Specifically, we (virtually) invest every quarter, during 1986-2018, three months before the quarterly earnings announcement, in all the public companies that will at the subsequent earnings announcement exactly meet, or even better beat the analysts’ consensus forecast of earnings. This is the “dream” of managers. The investment is sold after the earnings announcement and the gain/loss computed. The figure shows the average gains from such a perfect foresight of forthcoming GAAP earnings.

It is clear from the figure that while knowing ahead of time the companies with successful future earnings was lucrative in the 1980s and 1990s, these gains dropped continuously and sharply in the past two decades. Today, even if you could predict and invest in all the companies that three months hence will disclose successful earnings, you won’t be able to make serious money (less than 1%). Stated differently, GAAP earnings gradually lost their ability to reflect real performance of companies and their change of value. Good GAAP earnings don’t mean much.

I have written extensively in this blog, and in the book, The End of Accounting, about the reasons for this relevance lost of GAAP earnings. Primarily, the absurd accounting procedure of immediately expensing in the income statement all intangible investments (R&D, IT, brand enhancement, investments in human resources, etc.). The result is that 70% of all high tech and science-based companies now report annual GAAP losses, and this is a booming economy. An absurdity if I have seen one. But that’s not the only “contribution” of the FASB to accounting. The emphasis of accounting regulators on fair-valuing assets and liabilities inserts into the income statement multiple one-time gains and losses (like assets or goodwill write-off: impairment losses), which are largely irrelevant for current performance valuation.

So, this is the reason for the proliferation of non-GAAP earnings: The irrelevance of GAAP earnings forces corporate managers to provide investors with more meaningful alternatives for performance evaluation. Sure, as with GAAP earnings, some managers will try to game the system by manipulating non-GAAP earnings, and provide misleading measures that are inconsistent over time. But by and large, non-GAAP earnings are serious attempts by managers to provide investors with more meaningful measures of performance. That’s the reason for the empirical studies showing that investors react more strongly to non-GAAP earnings than to the GAAP numbers.

So, next time people criticize non-GAAP earnings, I hope they will compare their relevance and usefulness to the data currently provided in financial reports courtesy the Financial Accounting Standards Board. By and large, non-GAAP earnings are useful to investors.

 

[1] See, Wall Street Journal, “WeWork Was Wrestling With SEC …” November 10, 2019.

[2] This figure is form Gu and Lev, 2017, “Time to Change Your Investment Model,” Financial Analysts Journal, 4th Quarter.

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