Adjusted Earnings – What’s Hiding Beneath Those Adjustments? by Richardson GMP
Every quarter companies report their earnings, they provide a detailed itemization of their business. After all that’s why we buy stocks, to own a piece of a business. As owners we want to know how the actual business is doing, as the price which moves every day is more a voting mechanism not a measuring stick. Stock prices are volatile, and are driven by human behaviour (increasingly machines as well) they move around based on market participates future expectations. At times they are overly optimistic and at times overly pessimistic.
Earnings season, the talking heads favorite time of the year can be a volatile time for stocks. It’s when we get greater insight into the inner operations of the business and snapshots of their balance sheet, income statement cash flow as well as comments from management discussing the quarter and what they see affecting the business in quarters to come.
Talk of inflation has been swirling for some time amid all the stimulus that's been pouring into the market and the soaring debt levels in the U.S. The Federal Reserve has said that any inflation that does occur will be temporary, but one hedge fund macro trader says there are plenty of reasons not to Read More
One of the most widely reported and arguably important numbers is a company’s earnings per share, most often reported on a GAAP basis (Generally Accepted Accounting Principles). However companies also report on an ‘adjusted basis’. These adjusted or operating earnings can be differ from GAAP earnings for many reasons.
To go from non-GAAP to GAAP earnings, what companies adjust for should be reclassified or omitted. Interest, taxes and employee stock compensation, goodwill, depreciation are the usual suspects. That said, companies have become more clever, or sneaky, depending on how you look at it
Firms are excluding more and more items. According to the WSJ, these items include: regulatory fees, “rebranding” expenses, pension expenses, costs for establishing new manufacturing sources, fees paid to the board of directors, severance costs, executive bonuses and management-recruitment costs.”
Part of the problem is incentives. High-level compensation is often linked to earnings-based performance metrics. As such, executives are motivated to do whatever it takes to maximize their payouts.
Sometimes, adjusted measures provide investors with a more complete understanding of a business. Even so, they limit comparability across results, which goes against the purpose of accounting standards.
You’ll often see terms like ‘extraordinary’, ‘one-time’, ‘special items’ when they report their adjusted earnings. Sure extraordinary events sometime are worth backing out of the quarterly numbers. What is a somewhat disturbing trend is that the number of companies reporting adjusted earnings is on the rise. As you can see from the chart on the first page, the percentage of companies reporting adjusted earnings on the S&P 500 rose to 90%, up from 70% in 2009. Is this a sign that companies are trying to hide the fact that they are generating a lot less earnings power than the headline numbers would indicate?
The spread between adjusted and GAAP earnings has been growing. Looking back to 1988 we looked at the difference between GAAP and operating earnings on the S&P 500. To smooth out the quarters we looked at the eight year period moving average of the difference between the two. After coming in lower following the financial crisis this difference has been steadily widening out over the past six years. In percentage terms, the 13.35% difference between our smoothed difference and GAAP earnings is the widest since 3Q 2010. Indeed, earnings quality has been waning for some time. This doesn’t help the argument that what we’re seeing is an illusion on the health of corporate America, it also raises some interesting questions. Should we care that companies are writing off a large amount of good will? Is there a correlation between M&A activity and the divergence in what we are seeing? Certainly following a year of record M&A activity, companies in aggregate would be writing off plenty of one-time charges.
So why do we use financials?
- To see what a company is worth
- For comparability between different time periods as well as between companies
Extraordinary items can fudge quarterly numbers to throw these reasons off. Yes, the constantly changing business world sometimes require companies to make one-time adjustments. Their health might be fine, it’s simply a symptom of a more dynamic business environment. Although adjusted earnings from continuing operation have diverged from GAAP earnings, a large portion of this has come from write-downs in cyclically exposed sectors. With oil prices loosing half their value in the two years and other industrial materials following suit, cyclically exposed sectors have had to take massive write-downs to account for the new market value of their assets and reserves. It is likely that as commodity prices have stabilized, particularly oil, the bulk of these write-downs have taken place and the worst is behind us. As economic growth stabilizes this factor should dissipate and the difference should close. This can have an impact on valuations, most analysts value companies based on operating earnings not GAAP earnings. As operating earnings close the gap, it should improve the valuation multiple attractiveness.
Many think that deteriorating earnings quality is a leading indicator for the economy; but it actually tends to be a lagging indicator. We saw earnings quality deteriorate in 2015, but this was also on the heels of weakening economic conditions in both Canada and the U.S. Leading to the aforementioned write-downs. As commodity pricing rationalizes it is expected that the quality improves. There was also a slew of write-downs from the technology sector that is undergoing an evolutionary period where legacy assets simply aren’t worth what they once were and speculative new tech bets just didn’t pan out. These are truly one off instances and not indicative of the general direction of the economy.
Earnings Quality at the company level
Looking at S&P 500 index members, we analyzed company earnings. Specifically we compared earnings per share from continuing operations with adjusted earnings per share (for those accountant included). Essentially this is comparing earnings with earnings after a few adjustments. There is some good news, the median difference has remained relatively stable over the past decade at about 2% variation. Meaning adjusted earnings were adjusted about 2%. Some much higher but some not adjusted at all.
So does this matter for performance? Maybe. Of the companies analyzed, we compared the top quartile (those that adjusted earnings the least) with the bottom quartile (those that adjust earnings a lot). The top quartile companies had a 10 year annualized return of 11.9% while the bottom quartile was 8.1%. That may be meaningful but it could also be capturing a sector tilt as there were some sectors that earnings quality is certainly lower. Health Care and Information Technology were the biggest culprits of adjusting earnings the most. Consumer Discretionary, Industrials and Materials had the lowest adjustments to earnings.
The biggest lesson here may be that earnings quality does matter but it is probably a company by company issue. One of the reasons we never owned Valeant was its earnings quality or more accurately the massive divergence between reported and adjusted earnings. Over the past five years the company has reported earnings totally $7.46 while the total adjusted earnings were $32.21.
Charts are sourced to Bloomberg unless otherwise noted.