When the Unicorn Eats Your Earnings

S&P 500: Operating Vs. GAAP EPS
Trailing Four Quarters (T4Q)

Heartland Advisors Value Investing S&P 500 Operating verses GAAP EPS chart
Source: Wolfe Research Portfolio Strategy, Standard & Poor’s, Compustat, Thomson Reuters, and FactSet Research Systems Inc., 12/31/1987 to 6/30/2017. Generally Accepted Accounting Principles (GAAP) and Earnings Per Share (EPS). IBES (owned by Thomson Reuters) calculates consensus bottom-up earnings expectations over the next 12 months for each U.S. company. These earnings are aggregated into one earnings number for the overall S&P 500. Areas highlighted in gray represent recessionary periods: July 1990 to March 1991, March 2001 to November 2001, and December 2007 to June 2009.
Economic predictions are based on estimates and are subject to change.
Past performance does not guarantee future results.

They are the unicorns of the corporate accounting world—those “once-in-a-lifetime” charges that creep into quarterly results with remarkable regularity. In financial releases, they are tagged as adjustments and ignored in calculations of non-GAAP earnings.
Originally utilized sparingly as a way to explain unique events, businesses, as shown, have become more aggressive in using the trick to turn lackluster results into income growth. Of course not every company relies on adjustments but we have noticed an uptick in those excluding items ranging from pension costs to stock options when reporting results. For example, Netflix, Inc. (NFLX) backs out stock-based compensation in its adjusted earnings, even though the cost is more than 20% of general expenses and is the third largest expenditure behind only marketing and content purchases. This expense is real and could result in shareholder dilution in the years ahead, yet the only way to find it is to dig through SEC filings.
For active investors, the solution is straight forward—comb through profit and loss statements, evaluate accounting changes to determine if they are extraordinary events, and develop a realistic view of results to determine a business’ intrinsic value.
Passive investors don’t have that luxury. They can’t avoid companies that have come to rely on these “rare” adjustments. Instead, they are forced to buy and sell an index based purely on companies’ market value—regardless of valuation or accounting practices. When investors eventually turn their attention back to the quality of profits, passive investors may wish they’d been more selective.
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Heartland Advisors Value Investing Research Analyst Troy McGlone

Troy McGlone

McGlone, CFA, is a Research Analyst. He has 10 years of industry experience, 4 at Heartland.

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