The bullish earnings story underlying the stock market may be a big lie
We recently got some good news: After five consecutive quarters of decline, earnings growth returned to S&P 500 (^GSPC) companies. The earnings recession ended.
The resumption and acceleration of earnings growth is at the core of most experts’ bullish forecasts for the stock market.
But what if it’s all a big lie?
This relates to a matter that Yahoo Finance has been reporting on for a while.
Beware the “GAAP gap”
When accounting for business, CFOs are guided by a standard known as generally accepted accounting principles, or GAAP. GAAP represents an attempt to promote uniformity in how companies report their financial performance.
But income statements reported based on GAAP don’t always do a good job of reflecting the ongoing performance of a company’s underlying operations. GAAP earnings will include a lot of non-recurring or one-time items like asset write-downs and restructuring costs. These items distort quarterly profits and arguably misrepresent long-term profitability. And so, a company will also provide an adjusted, or non-GAAP earnings number that excludes what are arguably non-recurring items.
Unfortunately, non-GAAP earnings often reflect a lot of liberties taken by managers aiming to inflate their numbers.
“There are mixed opinions in the market about the use of non-GAAP EPS,” FactSet’s John Butters said on Friday.
“Supporters of the practice argue that it provides the market with a more accurate picture of earnings from the day-to-day operations of companies, as items that companies deem to be one-time events or non-operating in nature are typically excluded from the non-GAAP EPS numbers,” Butters continued. “Critics of the practice argue that there is no industry-standard definition of non-GAAP EPS, and companies can take advantage of the lack of standards to (more often than not) exclude items that have a negative impact on earnings to boost non-GAAP EPS.”
The magnitude of the gap between GAAP and non-GAAP earnings is illustrated starkly by the financial results of the Dow Jones Industrial Average (^DJI) during in Q3 earnings season.
“For the 21 companies in the DJIA that reported non-GAAP EPS for Q3 2016, the average non-GAAP EPS growth rate was 10.8%, while the median non-GAAP EPS growth rate was 5.1%,” Butters observed. “For these same 21 companies, the average GAAP EPS growth rate for Q3 2016 was -3.7%, while the median GAAP EPS growth rate for Q3 2016 was -1.2%.”
An important caveat from Butters: “The average difference between non-GAAP EPS and GAAP EPS for the DJIA was unusually large because of DuPont. For Q3 2016, DuPont reported non-GAAP EPS of $0.34 and reported GAAP EPS of $0.01.”
This massive discrepancy demonstrated by DuPont is a great example of why investors shouldn’t just blindly rely on non-GAAP or GAAP numbers. Rather, they should do their homework and research why the numbers came out the way they did.
Be mindful
The “GAAP gap” debate is not really about choosing between GAAP and non-GAAP numbers. Rather, it’s about understanding what the different numbers are telling us.
“Be mindful of the gap between GAAP and non-GAAP EPS,” Deutsche Bank’s David Bianco wrote on Friday.
Bianco explained.
“Over the past two years, the wider than usual spread between GAAP and non GAAP is from asset write-downs at Energy and Materials companies,” he observed. “Outside those sectors, the spread at ~87% ex huge discontinued operations and one-time gains at Health Care (AGN, DVA) is in line with normal. The overall spread bottomed at 68% in 4Q15 and subsequently improved to ~81% in the past two quarters and ~84% QTD. In addition to write-downs, stock option expense (SOE) is often excluded by new Tech, bio Tech and some tech oriented consumer stocks. 42 S&P companies exclude SOE from their non-GAAP EPS, and that SOE would have had $1.07/sh impact to S&P EPS.”
While investors should be mindful, they should also probably err on the side of caution.
“It is also true that in a number of cases management compensation is based on adjusted EPS, thus providing a powerful incentive to report as much in terms of non-recurrent items as possible,” Macquarie analysts Viktor Shvets and Chetan Seth wrote in an August note to clients.
“It is not clear to us how long companies can continue with this practice, however if history is any guide, we may be closer to a point where opportunity for easy ‘cost take-outs’ might be approaching an end, although one should be always careful of underestimating management capabilities when incentives are so powerfully lined-up in favor of adjustments.”
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Sam Ro is managing editor at Yahoo Finance.
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