GAAP vs Non GAAP
Hi,
does anyone have a good article/reading material on how to evaluate GAAP vs non GAAP earnings numbers please? Thanks!
Hi,
does anyone have a good article/reading material on how to evaluate GAAP vs non GAAP earnings numbers please? Thanks!
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Hey Chimp_and_jeez, the following topics might be helpful:
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Fingers crossed that one of those helps you.
Interested!
They usually provide reconciliations from non-gaap to gaap. Analysts usually make their own tweaks and then analyze based on that. Looking at the reconciliation should give you the info you need to understand it.
Will second this -- at a previous role, we'd provide GAAP and Non-GAAP figures for a very limited (i.e. 3) numbers and the resulting reconciliation.
Non-GAAP can be great for actually managing the business, but be mindful that these standards were put in place for a reason...there needs to be a good balance
The reason the standards exists is the accountants designed a system that prior frauds couldn’t cheat, but has the problem that it misses a ton of real economic value.
There’s a massive amount of companies that have negative book value now that have a real economic value that’s huge.
GAAP is close to fraud proof, but it’s not an accurate measure of earning or asset values.
Depends on the items. The market accounts for some items depending on the industry. Read the notes in the financial reports.
thanks!
To think about the legitimacy of GAAP vs. Non-GAAP earnings figures (EBITDA, Net Income, etc.), you need to have some definition of what that earnings number should mean, and then consider whether GAAP or Non-GAAP is doing a better job of representing that underlying economic reality.
Let's start with Net Income. My working definition of what Net Income should accomplish is to: represent the sustainable economic free cash flow of the business before reinvestment in growth. I think good/useful non-GAAP adjustments are those that make Net Income better line up with this definition.
Note that I'm picking my words carefully in the above definition. I use "sustainable" because it's important that net income appropriately capture required maintenance capex (through a good D&A estimate), while excluding one-time gains/losses of cash flow related to working capital shifts, etc. I use "economic free cash flow" because SBC, payments in kind, etc., can increase cash flow but they come at a non-cash cost (dilution, etc.). And I use "before reinvestment in growth" because net income shouldn't include the impacts that investments in growth (growth capex, working capital, etc.) might have on cash flow.
With that definition in mind, let's consider a few GAAP vs. non-GAAP adjustments which we can evaluate for their validity. This isn't supposed to be an exhaustive list, but hopefully the logic I present here can help show you how to assess new/different situations.
COGS & Inventory Step-Up
When a company acquires another company, as part of acquisition accounting, the inventory of the acquired company must be valued up to near the market price (basically the market price minus the cost one might hypothetically pay a distributor to bring the goods to market)
Let's say Widgets Consolidated acquires a smaller company, John & Sons Widgets, which produces widgets and had 300 widgets in inventory, produced at a cost of $50 each. The purpose of the acquisition is to acquire the John & Sons' factory to expand production. The acquired widgets are revalued to $100, just under the market price of $101. As a result, when these widgets are sold, they run through COGS at a total cost of $30,000 instead of their $15,000 cost to produce, compressing gross margin. The company adjusts out that $15,000 cost from their adjusted numbers
Is this adjustment fair, in terms of improving Net Income's ability to represent sustainable economic free cash flow before investment in growth? I think it is. In the future, when the John & Sons factory produces more widgets, they will be produced at a cost of $50, not $100, and the gross margin will be ~50% on those goods, not ~1%. Thus before the adjustment, GAAP Net Income understates true economic Net Income.
Is this adjustment always fair for every company? No, certainly not. Let's say Liquidators International purchases John & Sons Widget Co. instead, not to run the business, but to wind down operations and liquidate their remaining inventories. Now, the underlying business model is built around acquiring inventories through acquisition to liquidate. The true price of those inventories is the estimated cost to purchase them by acquisition. While the acquisition-related inventory step-up is not necessarily perfectly accurate (it still has to allocate value to the factory, etc.), it's probably far closer to the truth than valuing the inventories at historical cost, as Liquidators International will not be producing any more inventories at historical cost in the future, and will need to do more acquisitions to sustain their revenue base.
SG&A & Restructuring
Let's say a new CEO takes over Electric-General Inc. He concludes the company has been poorly managed for many years and announces a large restructuring. The restructuring takes a year, and costs $700M in severance, consulting fees, etc.. SG&A had been flat for several years at $3,000M. This year it rises to $3,700M, evidently driven by the restructuring. The company adjusts out the $700M charge.
Is this a fair adjustment? Restructuring charges are tricky, but I think this is a more-or-less fair adjustment. While the charge is a true cash charge, and is definitely a cost to shareholders this year (it is $700M that they won't get, after all), it is reasonable to assume the restructuring is not part of the ongoing costs of running the business after this year. Going forward, SG&A will likely not include that $700M and thus the $700M is not representative of a cost of doing business on a sustainable basis.
Is this adjustment always fair, for every company? Again, certainly not. In particular, if Electric-General adjusts out significant restructuring charges every year, then the restructuring charges are an ongoing cost of business, and are evidently required to maintain current levels of profitability. In that case, they should not be adjusted out of Net Income.
Where things get a bit ambiguous is when restructuring charges are infrequent, but not all that rare, and are highly "chunky," huge in some years, 0 in others. In such cases, I tend to think it is OK for a company to adjust out the restructuring charges, so analyst can see what the "base level" of SG&A was this year. But an analyst might, in his model, try to estimate the average level of restructuring costs over the last 5 or 10 years and use that number as an additional cost when thinking about appropriate earnings multiples, likely FCFE over the next few years, etc.
Non-Cash Interest
Pharmaceuticals International adjusts out non-cash interest "payment in kind" interest from its Net Income definition, noting that this is a non-cash cost that doesn't impact free cash flow. The interest is, in effect, added to the debt balance, but there is no cash cost today. Is this fair?
This is almost always not a fair adjustment (there are a few unusual exceptions, but we can ignore them for simplicity). The non-cash interest represents a true economic liability that will eventually have to be paid. Thus while the non-cash portion of interest is not a cash charge today, that benefit is not sustainable indefinitely.
Quiz
Just for fun, what are your thoughts on these adjustments?
-Adjusting out impairment charges?
-Excluding non-cash taxes
-Adjusting out PP&E step-up related depreciation
-Adjusting out legal settlement costs?
If you want to let me know your thoughts, I'm happy to discuss your answers.
Hope this is helpful!
Simply outstanding, would give you 2+ SBs if possible. I am literally going to copy and paste this post to my notes in order to refer to it at a later date.
Thanks Bob! That’s very kind of you to say.
Building a standalone for the company (Gaap vs. Non-gaap) (Originally Posted: 04/30/2016)
Hey. Trying to build a standalone for the company based on its historical financials (8K, 10k) and research report.
One issue I have is, if I drive down from EBITDA, - D&A to get to EBIT, etc... I will arrive at non-gaap EPS, which I am actually trying to target.
However, equity report, when calculating the Cash flow numbers, are starting from Net Income (gaap). Of course, I'm not trying to use the cash flow number from the report, but just wondering how I would be able to reconcile the two different net income (gaap vs. non-gaap)
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