Accounting is commonly perceived as cut and dried. I once had dinner with an interior decorator, who, upon discovering I was in finance, said with some pity, “Well, you can still be creative, right?” My answer, of course, was that if we’re too creative, we go to jail. That pretty much ended the discussion (and got me in trouble on the way home).
My quip aside, accounting involves significant questions of judgment and adjustment. Take Enron, for example. The case was largely a matter of how the accountants reflected the business reality through the legal structure and financial statements. Although it was ultimately concluded that the statements didn’t reflect reality, both the internal financial managers and auditors agreed, at least initially, that the methods used were acceptable.
The obvious extension of this line of thought is to current corporate profits. There’s been a great deal of discussion, including here, about the valuation of the stock market that is based on earnings levels. We’ve discussed profit margins, sales levels, and many other factors.
What I haven’t brought up in any detail (because I’ve more or less assumed it) is what type of earnings to use. I prefer GAAP earnings—that is, earnings that conform to Generally Accepted Accounting Principles. These are required in financial reports and are all based (subject to some degree of judgment) on the same rules. If you want real comparability, either between companies or over time, this is as good as it gets. The rules underlying these reports represent the combined best judgment of the accounting profession.
Companies are required to report GAAP data, but, increasingly, they report non-GAAP numbers as well. Perhaps surprisingly (or perhaps not), these metrics are usually more flattering to the company and to management than the GAAP numbers. Typical non-GAAP numbers are operating earnings, EBITDA, or cash earnings.
The argument behind non-GAAP numbers isn’t bad: to better reflect the company’s financial performance, absent one-time charges or factors that are changing, or simply to better reflect the ongoing reality of the company. Note, though, that each of these requires deciding what is short-term, what is one-time, or what is ongoing reality—a decision made by management, which has an interest in the results. Note also that these numbers require omitting information. Analysts looking at GAAP numbers can review all the information and make their own adjustments, if warranted. Non-GAAP numbers can be like a doctor not giving you all the information about your health, so as not to worry you.
Looking at empirical results, we consistently find that non-GAAP numbers provide a more favorable picture of corporate performance than GAAP numbers do. This is why companies provide, and publicize, non-GAAP numbers.
The problem is when non-GAAP numbers are used as the basis for valuations. Because there’s really no consistent standard for non-GAAP numbers, either between companies or between time periods, it is much more difficult, if not impossible, to make those comparisons. The fact that the numbers are also based on limited information, “earnings without the bad stuff,” makes analysis even more problematic.
So, when you see stock market valuations that are based on operating earnings or other non-GAAP numbers, some caution is warranted—and even an assumption that these numbers are more favorable than they would be if all of the information were included.
I started thinking about this after taking a quick look at two papers by a business professor named Robert Novy-Marx. He evaluates stocks based on gross profitability (which is defined as sales less cost of goods sold, divided by assets), and proves that this adds value to returns over time.
What’s interesting about these papers, in this context, is that they explicitly remove the “earnings” aspect of stock valuation and, therefore, a great deal, although not all, of the accounting aspects. Accounting issues remain—sales accounting can be massaged, and asset accounting is also subject to judgment calls—but the closer you get to the top line, the cleaner the number.
The fact that models like these apparently can generate excess returns calls into question the value of the accounting-based analyses used to justify non-GAAP numbers, and even those of GAAP itself.
Novy-Marx’s models have weaknesses of their own and certainly aren’t a panacea. They serve, however, to highlight the caution investors should use when evaluating current market valuations. Every layer of abstraction—whether accounting (GAAP to non-GAAP, or sales to earnings), time (forward earnings versus historical earnings), or any other method—removes the investor from the actual economic performance of the business and injects more uncertainty, which can’t be good for your portfolio.