The SEC has for many years expressed concern about the widespread and increasing use of non-GAAP earnings measures in public company press releases and other regulatory filings. Part of the SEC’s concern has to do with the prominence with which non-GAAP earnings are displayed in earnings releases. The Commission has issued rules requiring that the comparable GAAP figures be displayed at least as prominently in earnings releases as the non-GAAP figures. In addition, SEC rules require that companies provide a reconciliation of the non-GAAP figures to the comparable GAAP measures within their earnings releases.
The SEC is also concerned about the widening gap between GAAP and non-GAAP results. This widening may reflect either efforts by SEC registrants to promote their stocks or to mask a deterioration in their performance or both. If so, then at least some non-GAAP measures may be misleading.
The Commission may be correct in seeking to protect less sophisticated investors from this trend, but the non-GAAP disclosures do provide investment professionals with a useful tool to assess a company’s performance and future prospects.
The rationale for non-GAAP measures is based upon the view that they provide a better assessment of the “core” or future sustainable earnings (and cash flow) of a company. Excluded items are supposed to be either non-cash or temporary in nature. The composition of non-GAAP earnings can include information that may not be available in other company communications or SEC filings.
S&P 500 Operating Earnings. Non-GAAP measures are widely communicated. They affect our assessments of stock market valuations, especially for key benchmarks like the S&P 500. Investment strategists, portfolio managers and analysts alike utilize S&P’s notion of “operating earnings”, a non-GAAP measure, in their valuation assessments of that index.
It is hard to find a precise definition of S&P 500 operating earnings. Based upon what I have been able to piece together, it appears to exclude corporate expenses, one-time asset write-offs (including goodwill write-offs), gains or losses on pensions and asset sales, expenses related to settlements of litigation and insurance claims and other unusual items. It is calculated on a “bottoms-up” basis (i.e. by adding up the market-weighted operating earnings of each individual company within the index). It also utilizes analysts’ projections for forward estimates.
If, in fact, S&P operating earnings exclude corporate expenses, I believe that the measure is flawed. I understand that S&P may be seeking to get at the underlying profit of the constituent companies’ operations, but corporate expenses are recurring and so have a clear impact on individual company valuations. In most cases, the operating segments of these large companies would have to assume many of the costs borne by their corporate headquarters to run their businesses on a stand-alone basis. The allocation of certain expenses between corporate and the business segments is based upon individual company policies. So in fact, the corporate expenses of some S&P 500 companies may be included in S&P operating earnings. Accordingly, S&P’s definition of operating earnings may overstate the true profitability of index constituents.
EBITDA or earnings before interest, taxes, depreciation and amortization is the most widely-used non-GAAP metric. EBITDA is also often called “operating cash flow.” It is meant to provide a measure of the cash generated by a company without regard to its debt costs or tax policies. Accordingly, it is a measure that facilitates valuation comparisons within a given industry among companies with different capital structures.
The primary flaw with this measure is that it adds back depreciation (a non-cash expense) without considering the capital costs required to sustain that cash flow. For that reason, many companies also disclose “maintenance” capital expenditures or that portion of total capital expenditures that is deemed to be required to sustain profitability. These are distinguished from “growth” capital expenditures, which are incurred to grow profits, cash flows and EBITDA. Likewise, expenditures for acquisitions are not factored into EBITDA because they are considered to be similar to growth capital expenditures.
There is no standard definition of maintenance capital expenditures. I do not know of any company that describes how it distinguishes maintenance from growth capital expenditures. Consequently, investors have no assurance that the level of capital expenditures designated by a company as maintenance is actually sufficient to maintain its EBITDA.
Likewise, some capital expenditures may be designated as growth when they might rightfully be considered maintenance. For example, capital expenditures incurred for a new product that is intended to replace an existing product that is becoming obsolete might be considered maintenance, because they are intended to maintain the company’s profitability by offsetting the decline in profits from the existing product. By similar reasoning, acquisitions made to replace old products or product lines may also be akin to maintenance capital expenditures.
Without improved disclosure, it seems to me that the best and perhaps the only way to determine whether growth capital expenditures are properly characterized is to calculate whether the company is achieving profit growth that is commensurate with its growth capital expenditures while sustaining its return on capital employed.
Although many analysts, including myself, use EBITDA multiples to compare valuations of companies within an industry, such analyses are imperfect because the comparisons do not consider the condition of each company’s capital assets and the expenditures required to keep them in good operating condition. It is likewise risky to use EBITDA alone as a measure to assess a company’s ability to service its debt without also factoring in an estimate for required capital expenditures.
Funds from Operations (FFO) is another non-GAAP metric used exclusively by real estate investment trusts (REITs) to gauge their performance. FFO is defined simply as net income plus depreciation on real estate assets. “Normalized FFO” is FFO excluding unusual items such as impairments, acquisition costs and debt extinguishment costs. “Adjusted FFO” is normalized FFO minus other charges that are typically included in non-REIT non-GAAP calculations, such as non-real estate depreciation and stock compensation expense. Some companies also subtract out maintenance capital expenditures to arrive at adjusted FFO.
FFO is also considered a rough proxy for REIT taxable income, of which 90% must be distributed to equity investors annually in order for the REIT to maintain its tax exempt status with the IRS.
The original premise behind FFO is based upon the notion that depreciation frequently overstates the cost of maintaining real estate properties. Real estate assets are long-lived and properties can often operate for many years without having to undertake major repairs or upgrades. Thus, many REITs should generate more cash than earnings, resulting in surplus cash that can be distributed safely to shareholders without compromising the sustainability of cash flow over time.
Yet, even though many REITs disclose their maintenance capital expenditures, it is not clear whether their assessments are accurate. Property upgrades may be important in certain real estate classes, such as hotels, in order to maintain their competitive edge. In certain categories of real estate, therefore, it may not be enough to ensure that the roof does not leak. It is often difficult for outsiders to determine whether a REIT is spending enough to maintain its competitiveness.
Stock-Based Compensation Expense. Many companies include stock-based compensation expense in their non-GAAP earnings because it is non-cash. Technology companies, in particular, have included stock-based compensation in their EPS adjustments, because this has traditionally been a large cost especially for start-up companies that may distort the growth in earnings and cash flow that they are achieving in their early years. Even so, for many technology companies, the practice of excluding stock compensation costs from profit measures often continues well past their start-up phases, even as they have evolved into mature companies.
Although stock-based compensation is non-cash, it nevertheless has value and affects the returns of all shareholders. For that reason, I believe that it is generally not appropriate to add back stock-based compensation in the determination of adjusted or non-GAAP earnings. However, it is acceptable for debt investors to add back stock-based compensation in their determination of EBITDA or cash flow available to service debt, except in situations where a company has adopted a policy of expending cash to buy back the increase in shares caused by the issuance of stock-based compensation.
Adjusting “Non-Cash” Expenses for the Associated Cash Expenditures. Like EBITDA, there are a number of “non-cash” expenditures that are often included as adjustments in the determination of non-GAAP earnings, but for which the associated cash expenditures are excluded. For example, some mining companies treat the accretion of their asset retirement obligation liabilities as non-cash in non-GAAP calculations, but they do not then include or add back the actual cash payments made to meet those obligations.
Amortization of other capitalized costs, such as software- or marketing-related expenses, if included in the determination of any “non-GAAP” measures, should likewise be offset by the corresponding cash expenditures made for those line item categories for the period.
Similarly, earnings on unconsolidated equity investments are non-cash and thus should be excluded in calculations of EBITDA or non-GAAP earnings, but the actual cash distributions received on those investments (i.e. dividends) should be included in those measures.
The same can be said for certain unrealized gains and losses on derivatives and hedging programs. These unrealized gains and losses can add volatility to reported results, especially during periods of wild swings in commodity prices. For that reason, excluding those unrealized gains can provide investors with a better picture of a company’s base performance, as long as the realized gains and losses are included as they occur.
The Problem of Recurring Non-Recurring Expenses. One of the primary rationales for non-GAAP measures is to adjust for so-called non-recurring expenses. Examples include restructuring costs, acquisition-related expenses and unusually high litigation costs. Because these are considered non-recurring, they are intended to provide a better perspective on future earnings prospects.
It is often the case, however, that such expenditures are not non-recurring. Restructuring is an ongoing process in many businesses. It may make sense to adjust earnings for unusually high restructuring costs in a given year in order to prepare a more realistic forecast of a company’s future performance, but regularly recurring restructuring costs should be considered as an ongoing cost of the business.
Perspective Drives the GAAP vs. non-GAAP decision. Analysts should parse non-GAAP earnings to inform their assessments of a company based the type of securities that they are analyzing and the time frame of their analysis. As noted above, adding back non-cash stock-based compensation costs may be more appropriate for the debt analyst who is primarily concerned about the adequacy of the company’s cash flow to service its debt, than for the equity analyst, because shareholders bear the cost of such compensation.
Non-GAAP earnings measures can help guide those who are looking at a company prospectively; but GAAP earnings are more relevant for an analysis of historical performance. Non-GAAP earnings can form the base upon which projections of future performance can be built, assuming of course that the adjustments to GAAP earnings are truly “one-time” or non-recurring in nature.
When evaluating historical results, however, the GAAP numbers, adjusted perhaps to smooth lumpy charges (by spreading them out over multiple years), are a better indicator of performance. Impairment charges, for example, are a non-cash charge that has usually been taken against an asset for which there was a previous expenditure of cash. By ignoring the impairment charge, the analyst also risks overlooking that associated cash expenditure, resulting in a misleading picture of the company’s actual long-term performance.
The analyst might therefore want to compare the non-GAAP base figures against the historical GAAP performance. Do the two square? Would a projection based upon the non-GAAP results be consistent with the company’s long-term historical GAAP performance?
Non-GAAP Metrics Give the Investment Community Another Tool to Evaluate Company Performance. Despite the concerns about the increase use of non-GAAP earnings measure, sophisticated investors and investment professionals should view them as another tool that can be used to gauge a company’s historical performance and future prospects. Just as few analysts take reported GAAP net income as gospel and most adjust the GAAP numbers to reflect their assessments of the company’s application of accounting standards or its use of estimates in key line items that determine GAAP earnings, so they may rightfully make similar adjustments to the non-GAAP figures. Non-GAAP measures also provide a way to gauge management’s aggressiveness in promoting its stock price.
Originally published on September 26, 2016; revised January 11, 2018.
Stephen P. Percoco
839 Dewitt Street
Linden, NJ 07036
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