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Earnings Quality: Should Investors Mind The GAAP?

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Earnings quality has started to become a hot topic as the first quarter reporting season drags on and tech bigwigs Apple, Facebook and Twitter report this week. The gap between adjusted and GAAP earnings is growing, giving rise to the debate about earnings quality, but does that gap matter? Apparently it depends on how you look at it.

Does the widening gap signify worsening earnings quality?

Of course GAAP stands for “generally accepted accounting principles” and thus is designed to more clearly state a company’s earnings. However, the inclusion of so many unknown variable makes it difficult to analysts to predict GAAP earnings, which is why the use of adjusted earnings as a guide to predict results has become the norm.

The concern is that the widening gap between pro forma and GAAP earnings suggests that earnings quality is worsening, and two Morgan Stanley teams led by Adam Parker and Brian Hayes worked together in considering this question. They found that the gap between the two earnings metrics has widened to about 30%, which is alarming because this is the widest that gap has been since the third quarter of 2009. The MS team noted that investors are worried that this widening gap “is a symptom of a deteriorating earnings outlook for US equities and a signal for a pullback in the market.”

This gap might not be as concerning as some think

Parker – who while he has good points has also, by the way, written reports on controversial topics like the one about what he called “cockroach investors” winning right now as he seemingly bashed their tactics – and team said that a wide gap between pro forma and GAAP earnings doesn’t necessarily predict the market or stock returns. They said that when the spread at the market level is widening, it doesn’t necessarily signal an imminent sell-off, nor does it offer any guidance regarding a stock’s particular performance.

Additionally, they said that this gap doesn’t measure earnings quality very well. When looking at the “GAAP gap” against the accruals factor, another more widely accepted measure of earnings quality, they found a “persistent negative correlation.”

The Morgan Stanley team added that if the gap between GAAP and pro forma earnings actually mattered, there should be a closer correlation with “a demonstrably efficacious stock-return predictor like accruals, which is the disconnect between earnings and cash flow.” They believe accruals is one of the most effective long-term short signals on earnings quality that’s available.

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Two factors driving the GAAP gap

After examining last year’s quarterly filings for the 50 companies that account for the majority of the gap between GAAP and pro forma earnings, they said two main factors appear to drive it. The first they define as “true non-recurring charges largely attributable to companies with commodity related exposure.” They said 30% of the companies with a wide gap between the two earnings metrics are in the Energy sector, while half of their adjustments last year were related to impairments or discontinued operations.

The Morgan Stanley team defined the other as the “evolution of non-traditional and recurring adjustment items,” which make up the other half of the adjustments. They said these items more fully illustrate a company’s “true economics” and should not actually be adjustments. Among the examples they give is stock-based a compensation because usually it is recurring rather than one-time.

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Tech, Healthcare companies the biggest “GAAP gap” offenders

So while not all of the adjustments are concerns relating to earnings quality, Parker and team do see some concerns about some of them. They said the Tech and Healthcare sectors appear to be the worst offenders in terms of the second category, noting that in many cases, large economic items are just being adjusted out of the reported earnings numbers. In addition to stock-based compensation, another area of concern is intangibles amortization.

They believe that to determine valuation, earnings that include true non-recurring items should not have a multiple applied to them. They constructed this list of the companies with the biggest PE multiple differences:


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