By Paul Price
It used to be simple. Companies reported earnings in accordance with GAAP (Generally Accepted Accounting Principles). Media sources published the results in press releases. Traders and investors voted with their buy and sell orders, and the stock moved in the direction of the general reaction.
Over the past decade, company managements and sell-side analysts have been increasingly adjusting the GAAP data higher, using Non-GAAP numbers to show larger than officially accounted for profits.
The nonstandard measures of financial performance are far looser than GAAP numbers. Many times, these inflated results are the only ones widely circulated by the press.
Financial website Investopedia explains GAAP as follows…
"GAAP are imposed on companies so that investors have a minimum level of consistency in the financial statements they use when analyzing companies for investment purposes. GAAP cover such things as revenue recognition, balance sheet item classification and outstanding share measurements. Companies are expected to follow GAAP rules when reporting their financial data via financial statements. If a financial statement is not prepared using GAAP principles, be very wary!
On Non-GAAP numbers, Investopedia writes:
"Many companies report non-GAAP earnings in addition to the required GAAP earnings stating that the alternate figure more accurately reflects their performance. Some common examples of non-GAAP earnings measures are cash earnings, operating earnings, EBITDA (earnings before interest, taxes, depreciation and amortization) and pro-forma income.”
Managements must always disclose GAAP earnings, to make comparisons between companies easier. Often, however, the GAAP figures are buried in the footnotes of SEC reports and transcripts of earnings calls. Non-GAAP numbers are often more publicized. Companies would rather have analysts focus on higher ‘adjusted’ earnings per share (EPS) in order to make their stock valuations look cheaper.
Restating EPS in non-GAAP terms by adding back the very real cost of employee stock option expenses is now a common practice. It obscures true compensation levels, including those of company officers, while raising the EPS number.
Differences in reported data can arise from many sources. Other common adjustments come from merger-related expenses, revenue recognition decisions, any or all non-recurring items, and even the most appropriate number of shares outstanding to be used in calculating EPS.
On-line financial sites don’t always disclose when they are not using GAAP figures. This can make a huge difference in the reported P/Es that various research services carry for the same stock.
Pharmacy benefits management firm Express Scripts (ESRX) provides an example. Its shares closed at $62.98 on Monday, June 17, 2013. Here are the ‘Analyst Estimates’ sections for ESRX as shown on that date from Yahoo Finance, MSN Money and Value Line.
Yahoo Finance used Non-GAAP estimates in showing 2013-2014 projections of $4.30 and $4.93 respectively. It did not mention, or even footnote, that the numbers were not GAAP estimates. Readers using those numbers would come up with reasonably low P/E multiples of 14.7x and 12.8x expected earnings for this year and 2014.
MSN Money Central showed an almost identical set of estimates. Current year and 2014 multiples also look low for ESRX as a high-quality, conservatively financed growth company.
Value Line provides a very different set of estimates. Value Line’s research used GAAP accounting in coming up with 2013 and 2014 expectations of $2.70 and $3.30. Based on those numbers, this year’s P/E is 23.3x. The 2014 multiple would be 19.1x.
Value Line noted that Express Scripts’ management has said publicly that they project EPS of $2.80 for 2013, including any additional amortization charges from their 2012 purchase of Medco Health Solutions. It is mainly these non-cash charges - accounted for in the GAAP numbers but not in the non-GAAP numbers - that created the large discrepancy in reported EPS.
How would an investor know? You would expect that well-regarded sources of financial data could be relied upon for accuracy. How about two-out-of-three? Consulting MSN money would break the tie between Yahoo and Value Line, with estimates based strictly on non-GAAP numbers.
Taking time to read official company reports, with all their footnotes, will make you a better informed investor.
Deciding if a stock is reasonably priced means comparing apples to apples. Don’t get caught thinking a valuation is low by viewing adjusted figures against previously reported GAAP data.
Express Scripts is a large personal holding of mine. Whichever way you choose to calculate its earnings, the company appears to offer solid growth prospects.
Disclosure: Long ESRX shares
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