[05/10/21] Non-GAAP Earnings -Wishful Thinking or Real Profits

On April 30, 2021, the Clorox Co. reported its financials for the quarter ended in March 31: Sales, $1.78 billion, were almost identical to same – quarter a year earlier, but GAAP (generally accepted accounting principles) earnings—a loss per share of 49 cents—tumbled 126% from a year earlier. The reason: the company recognized in the recent quarter a $329 million impairment (loss of book value) charge of goodwill and trademarks in its health, vitamins, and supplements business. Nothing unusual here, hundreds of companies decrease (impair) their goodwill values every year.

What drew wide attention was Clorox’s release of an “adjusted (Non-GAAP) earnings” per share number of $1.62, after adding (canceling) the $2.11 impairment loss per share to the GAAP loss of 49 cents. So, in terms of non-GAAP earnings, recent quarter EPS was only a modest 14% lower than a year-earlier, rather than the 126% drop on a GAAP basis. Quite a difference.

Clorox justified the elimination of the goodwill impairment charge from earnings thus: “Management believes that the presentation excluding the impairment charges is useful to investors to assess operating performance on a consistent basis by removing the impact of impairment charges…” This makes sense to me. If the purpose of earnings (net income) is to indicate corporate performance and guide future profitability, then a one-time expense (impairment charge) related to acquisitions decisions made years earlier should not cloud current profitability. Most companies don’t impair goodwill every quarter, or even year. Moreover, given Clorox’s flat sales in the recent quarter, an earnings drop of 14% (non-GAAP) seems much more reasonable than the GAAP-driven 126% earnings dive.

Despite the reasonableness of Clorox’s non-GAAP earnings (Clorox’s peers Colgate-Palmolive and Procter & Gamble, by the way, release regularly non-GAAP numbers), all hell broke loose. The Wall Street Journal (May 4, 2021), for example, published an article titled: “Clorox’s Move to Provide Adjusted EPS Raises Concerns.” The article continued: “… some analysts view the change to how the consumer company measures its corporate value as potentially misleading.” Its quotes the Council of Institutional Investors saying: “Much to the dismay of investors, it has become increasingly common for large public companies to disclose ‘adjusted earnings’ or other financial measures that are not in accordance with GAAP.”

The “Dismay of Investors”? Clorox’s share price around the recent non-GAAP earnings release exhibited anything but dismay. On the day of earnings announcement (April, 30, 2021), Clorox’s stock dropped 2.8% (apparently, some investors still pay attention to GAAP earnings), but regained almost the entire drop by the following 2-3 days. But such hysterical reaction to non-GAAP earnings is typical. “Wishful thinking,” “Kool-Aid,” and even “fraud,” are common characterizations of non-GAAP numbers. Some even call on the SEC to outright ban non-GAAP earnings.

Frankly, I never understood the venom poured on non-GAAP earnings. Since GAAP (statutory) earnings have to be always provided along-side the non-GAAP numbers, if one suspects the integrity of the latter—just ignore it. You can’t be worse-off with non-GAAP earnings, which reflect managers’ perceptions of performance, as long as the statutory GAAP earnings are released. So, where is the problem? What’s the source of the alleged investors’ dismay? In fact, non-GAAP earnings (and other non-GAAP number, like revenues) aren’t just harmless, they are outright beneficial to investors, as the evidence overwhelmingly proves.

Given that the non-GAAP numbers are always released alongside the GAAP numbers, and that by SEC regulations, companies have to provide a full reconciliation between the GAAP and non-GAAP earnings, fleshing out the individual items (impairment charges, restructuring expenses, stock options) used to calculate the non-GAAP numbers, there is a huge amount of research―well over 100 papers—on the issue. Here are the main conclusions of this exhaustive research effort. They will surely surprise you:[1]

  1. Comparing investors’ actual reaction, judged by stock price changes, to the GAAP and non-GAAP numbers, the latter win by a landslide. In fact, investors trust non-GAAP earnings substantially more than their GAAP bretherens.
  2. In some cases, non-GAAP earnings seem to be aimed at manipulating investors (e.g., eliminating from GAAP earnings one-time losses, but not one-time gains), but these cases are few and far between. (Mind you, GAAP numbers are also occasionally manipulated.) Most non-GAAP earnings or revenues are honest attempts by managers to portray periodic performance and profitability on a recurring basis, facilitating the predictions of these variables.
  3. Most items eliminated in non-GAAP earnings are one-time (nonrecurring) expenses and gains related to asset write-offs, acquisitions, or restructuring charges, not expected to affect future earnings. Some companies also eliminate recurring charges, like expenses related to non-cash stock-based compensation, arguing that in managers’ view these are not operating expenses. If you disagree, just subtract the eliminated item from non-GAAP earnings.
  4. Given the SEC mandatory reconciliation between the GAAP and non-GAAP numbers requirement, any intelligent investor can easily assess the integrity of non-GAAP earnings. For example, it is suspicious if the company is inconsistent over time in the items eliminated (same item is eliminated one year, but not in the next), or eliminates items that its peers don’t. In such cases, ignore the non-GAAP earnings.
  5. Financial analysts, closely following public companies, also make adjustments to reported (GAAP) earnings. Researchers have shown that these adjustments are very similar to those made by managers in calculating the non-GAAP earnings, enhancing the integrity of the latter. Overall, the empirical evidence, and investors’ obvious preference for non-GAAP earnings, attest to their usefulness.

So it’s time to end the quarterly ritual of expressing dismay, even disgust with non-GAAP earnings. Few pay attention to this criticism anyway: Over 80% of S&P 500 companies persist in providing non-GAAP data, and as the evidence shows―most investors regard non-GAAP earnings as more relevant to their decisions than the accounting-based, and largely irrelevant GAAP earnings.

[1] For a comprehensive survey  of the research on non-GAAP earnings up to 2017, see Black et al., “Non-GAAP Reporting: Evidence from Academia and Current Practice, “Journal of Business, Finance and Accounting, 2018.


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