By Cornelius Zeeman,
Fairtree Portfolio Manager
“Fugayzi, fugazi. It’s a whazy. It’s a woozie. It’s fairy dust. It doesn’t exist. It’s never landed. It is no matter. It’s not on the elemental chart. It’s not real.” – Matthew McConaughey, as Mark Hanna in The Wolf of Wall Street.
These words come to mind when considering the earnings numbers reported these days by some companies in the United States. With the prevalence of non-GAAP earnings reporting, investors must exercise caution and scepticism to avoid being misled by these potentially distorted figures.
Non-GAAP Earnings.
Public companies in the US are required to report their financial statements with the SEC using Generally Accepted Accounting Principles (GAAP). However, they’re also allowed to present information to investors on a non-GAAP, or adjusted, basis. Management may supplement GAAP with non-GAAP measures to present a more accurate picture of ongoing business operations, cash flows, and operations. Most companies today present at least one non-GAAP measure, with adjustments more prevalent and material in growth sectors. While some adjustments are reasonable and reflect non-recurring expenses with no impact on a company’s future earnings power, many adjustments relate to persistent economic costs of doing business.
Typical Adjustments.
Common non-GAAP measures include adjustments for:
- Stock-based compensation (SBC);
- Amortisation of intangible assets;
- Mergers and acquisitions costs;
- Restructuring expenses
Figure 1 below illustrates how the Nasdaq’s non-GAAP earnings were 24% higher than GAAP earnings. This significant difference can have dangerous consequences for investment decisions if not approached with scepticism. The biggest adjustment item is SBC. In our process, we adjust free cash flow numbers by deducting this expense. Having a portion of employee cost as SBC increases your cash flows, but it also means the company needs to do buybacks to keep the overall share count static. The cash flow and non-GAAP numbers are therefore not a fair reflection of what shareholders receive at the end of the day.
Figure 1: 2023 NASDAQ 100 GAAP to non-GAAP earnings bridge
Growing Problem.
Figures 2 and 3 below illustrate the widening gap between GAAP and non-GAAP earnings, and how this has impacted the price/earnings ratio significantly over the last 15 years. For some technology companies, these adjustments can even turn a loss-making company into a profitable one. This trend could be a result of management incentives and reduced scrutiny of financial statements due to the growth of passive and quantitative investment strategies.
Figure 2: S&P 500 GAAP vs. non-GAAP P/E multiple
Figure 3: S&P 500 GAAP vs. non-GAAP P/E multiple spread
Conclusion.
Non-GAAP earnings measures can be useful when approached with caution, but they can also distort valuation multiples and return metrics. When investing, it is important to be sceptical and examine the numbers closely to uncover the true value of an investment. By digging through the dust, investors can uncover the gold and make more informed decisions.
Disclaimer:
Fairtree Asset Management (Pty) Ltd is an authorised financial services provider (FSP 25917). Collective Investment Schemes in Securities (CIS) should be considered as medium to long-term investments. The value may go up as well as down and past performance is not necessarily a guide to future performance. CISs are traded at the ruling price and can engage in scrip lending and borrowing. A schedule of fees, charges and maximum commissions is available on request from the Manager. A CIS may be closed to new investors in order for it to be managed more efficiently in accordance with its mandate. Performance has been calculated using net NAV to NAV numbers with income reinvested. There is no guarantee in respect of capital or returns in a portfolio. Prescient Management Company (RF) (Pty) Ltd is registered and approved under the Collective Investment Schemes Control Act (No.45 of 2002). For any additional information such as fund prices, fees, brochures, minimum disclosure documents and application forms, please go to www.fairtree.com
