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The Truth Behind Earnings – And How You Can Avoid Getting Hoodwinked

4 | By Shah Gilani

On Wednesday, I told you that companies and Wall Street analysts are playing a game with your money, and everyone’s in on it. The analysts, the media, the data compilers, and the company executives are all working in concert to make earnings look a lot better than they are.

Stocks can be affected by central bank policies, macro-global events, and existential crises. But in spite of, and especially in the absence of those “big-picture” market impactors, it’s earnings that drive stock prices.

But as I told you, headline earnings numbers fed to us by companies, analysts, and the media are more often than not jacked-up by means of creative accounting tricks.

The headline earnings reports investors take as gospel every quarter when the circus comes to town are non-GAAP, pro-forma, “Street” earnings, not bona fide earnings based on Generally Accepted Accounting Principles.

As you know, the difference between non-GAAP and GAAP earnings can be huge and can trap investors.

If you’re making investment decisions based on headline earnings metrics, and you don’t know what you don’t know, chances are you’ve been burned… or you’re going to get burned very soon.

Here’s some of the fluff you’ve heard, the underlying truth, and how, with just a little guidance, you can analyze real earnings yourself – just like the pros.

The Rift Between GAAP and Non-GAAP Numbers Is Getting Wider

Last year is just another example of the disparity between real and unreal earnings numbers. According to the Wall Street Journal, headline or pro-forma earnings for companies in the S&P 500 in 2015 were 25% higher than GAAP earnings. That’s the biggest disparity since 2008. A CNBC.com analysis found a similar gap in 2015 earnings.

In February 2016, regarding 2015 earnings, FactSet reported that:

…67 percent of the companies in the Dow Jones Industrial Average reported non-GAAP earnings per share and, on average, that the difference between the GAAP and non-GAAP earnings per share for these companies was approximately 30 percent, representing a significant increase from approximately 12 percent in 2014.

If you just follow the yellow brick road, paved for us by the likes of Bank of America Merrill Lynch, you’re probably feeling positive about the earnings reports coming at us like a fire hose this quarter.

A BoA report last week said,

With the conclusion of Week 2, 133 companies representing 40% of S&P 500 earnings have reported. Overall for the S&P 500, 67% of companies have beaten on EPS, 57% have beaten on sales, and 44% have beaten on both-an improvement from the prior week, and much better than we saw this time last quarter, when just one-fourth of companies beat on both EPS and sales.

Of course there are a lot of “beats” this quarter. Analysts have been furiously ratcheting down their earnings estimates since January, while company accountants, with executives standing tall over them, have been making “adjustments” right and left in their earnings and expense columns.

And regulators are starting to raise concerns that all this gimmickry is going to eventually cause trouble in the markets…

Regulators Are Starting to Take Notice

The SEC is worried about how investors are being misled.

Last month SEC chair Mary Jo White, addressing a U.S. Chamber of Commerce audience, told guests, “We have a lot of concern about the use of these measures and whether they may be confusing to investors and analysts.”

She shouldn’t worry they’re confusing to analysts – that’s bunk. Analysts know the game.

And SEC chief accountant James Schnurr criticized the rampant use of non-GAAP measures in a recent speech, saying, “SEC staff has observed a significant and, in some respects, troubling increase… in the use of, and nature of adjustments within, non-GAAP measures.” Schnurr additionally stated that non-GAAP measures should “supplement … not supplant” the information in the financial statements.

Even Warren Buffet’s been chiding non-GAAP earnings, noting the difference between GAAP and non-GAAP results is challenging for the average investor to interpret, and that they can’t count on analysts to clear it up because executives and some analysts are “guilty of propagating misleading numbers that can deceive investors.”

Case Study: GAAP Earnings vs. Non-GAAP Earnings

I want to illustrate the distinct difference between GAAP numbers and Non-GAAP numbers with two recent, real world examples.

You may have noticed that Apple Inc.‘s (NASDAQ:AAPL) earnings grossly disappointed this week – the company posted its first quarter-to-quarter revenue decline since 2003 – and the stock got beaten down.

Apple-Stock-Chart

The company released earnings after the bell on Wednesday, when the stock closed at $104.30. On Thursday, the stock opened 8% lower.

It’s disappointing, even troubling – since the company didn’t forecast any growth, and in fact lowered their guidance for Q3 – but Apple doesn’t report non-GAAP earnings, they only report earnings derived from generally accepted accounting principles.

While the truth hurt them, at least their investors know how the company’s really doing and can make investment decisions accordingly.

Facebook Inc. (NASDAQ:FB)? Not so much.

FB trumpeted their non-GAAP earnings on Wednesday after the close and the stock took off like a rocket.

Facebook-Stock-Chart

While the immediate focus was on the $5.382 billion in revenue FB posted for the quarter vs. last year’s revenue of $3.543, under the hood, non-GAAP numbers rolled out to the public masked less robust GAAP metrics.

FB pointed to income from operations being $2.977 billion, GAAP income was $2.009 B. Operating margins looked great at 55%, but the GAAP margin was 37%. And non-GAAP net income at $2.229 billion and diluted earnings per share of $.77 looked a lot better than GAAP net income of $1.510 billion and GAAP EPS of $.52.

That’s what good non-GAAP numbers can do, especially in a tough market looking for companies that clobber consensus estimates.

Still, Facebook is making huge strides no matter how they tell the tale of their earnings, so perhaps the stock would have gone up anyway.

But would it have gone up as much as it did? Maybe not.

How to Protect Your Investments from Shady Earnings Reports

So with all these different numbers, different accounting practices, and different reporting methods, what’s an investor to do?

My advice: When a company announces earnings, pay close attention. Read the reports, listen to the conference calls, and pay as much attention to the numbers they aren’t talking about.

Here’s a quick checklist that you can use to help you assess viability of Non-GAAP earnings numbers:

  • Always compare Non-GAAP and GAAP numbers side by side.
  • Make sure company executives adequately explain the reasons for the adjustments represented by Non-GAAP numbers. If they don’t, I don’t trust them.
  • If Non-GAAP numbers are the norm for the company, check explanations and footnotes to see if they are consistently calculated and when and why and how they’re applied from quarter to quarter.
  • Non-GAAP numbers work both ways – accounting for both nonrecurring expenses as well as nonrecurring gains, if some non-recurring gain magically fills what would otherwise be a bad number, apply the bad smell test to that entry.

Additionally, I always look at all numbers sequentially.

For example, I look at changes in top-line revenue sequentially over the past four quarters to a year ago, because how a company is doing in sales and generating revenue is hard to mess with.

If you look at all the components that make up earnings numbers through the sequential prism, it’s a lot easier to pick up anomalies anywhere they might otherwise be missed if that quarter’s numbers are just compared to the year ago quarter.

At the end of this earnings season, I’ll follow up with a complete breakdown of the highs and lows, the good, the bad, and the ugly stories that will give you the whole picture of 2016’s first-quarter earnings and how to value the market.

Sincerely,

Shah

4 Responses to The Truth Behind Earnings – And How You Can Avoid Getting Hoodwinked

  1. david louer says:

    Thanks for the article about non-Gaap vs Gaap earnings. The article in the New York Times on sunday 4/16 alluded to the same issue. You must know that the SEC has been paid off to look the other way,they are not interested in the truth,just appeasing corp.power.If you will review what has happened over the past 6-7 yrs,it is clear that the Federal Reserve,Supreme Ct in (Citizens United) have all been paid off. Our current gov’t is the most corrupt in history. The average joe is getting screwed virtually every day of his life,but they only complain,no overt action.

  2. Kathy johnson says:

    Thank you for this article. I learned a lot. I know I should listen on earnings calls and read the reports, but I haven’t. Now I have a plan. I appreciate your interest in educating us. Also look forward to seeing what you say on Varney.

  3. John Dantico says:

    Great instruction. Keep it up. Accurate information is critical to making prudent choices.

    When we live in a society of boastful liars, and the institutions that are supposed to work for the people, are run by morally bankrupt people, the people need to be alerted to what is going on and how the game is played.

    Thanks for speaking the truth.

  4. Kevin Beck says:

    As I see it, non-GAAP numbers are almost useless. I say “almost” because there can be limited use for these numbers.

    They have a use for seeing how often a business will resort to bending the rules in their reporting.

    They have a use when comparing extraordinary items, like gains or losses from sales of major production assets.

    They have a use if the types of events keep getting repeated.

    But mostly, they just represent garbage. And when garbage is a main input, it will also be the main output.

    I also agree that recurring uses of non-GAAP earnings shows that there are other problems under the hood. And this causes me to look away.

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