Analysis In The GAAP?
Cover Story, by Mark Robertson, Managing Partner October 31st, 2016
We’ve received a number of inquiries about accounting variations and the impact on business model analysis and return forecasts. We took a look at the forecast profile for the MANIFEST 40 and reach the conclusion that the arguments are pretty close to a square dance on the head of a pin.
Trust But Verify. Yes, Virginia, the historical data is often adjusted. This is essentially done to provide a “visualization” of the outlook for the company in the context of continuing operations. Using as-reported earnings can be particularly misleading or uninformative when trying to build our visions (models) of what our studied/owned companies may look like over the long term. Using the same approach we use for deep cyclicals and emerging companies, we avoid the tax-affected, tax-driven challenges and experience validation.
We’ve received a number of inquiries about accounting variations and the impact on business model analysis and return forecasts. Some have expressed concern over Value Line and resources that deploy conditioned data. First, Value Line has been doing this for almost 100 years. Second, they do stock studies just like we do … only they use cash flow and price-to-cash flow. This approach is basically immune to the concerns expressed. We took a look at the forecast profile for the MANIFEST 40, your most widely-followed stocks and reach the conclusion that the arguments are pretty close to a square dance on the head of a pin.
This year’s Berkshire Hathaway meeting included some commentary and discussion on accounting principles and the impact on earnings reported to investors. Buffett suggested that shareholders should ignore certain expenses, but noted that “it has become common for managers to tell their owners to ignore certain expense items that are all too real.” That is, in some cases the difference between the figures reached using generally accepted accounting principles and the adjusted non-GAAP numbers may be less about improving the numbers and more about artificially boosting earnings.
Some stock market pundits are highly critical of companies that repeatedly emphasize “adjusted” (also known as non-GAAP or pro forma) earnings over GAAP earnings. GAAP is short for generally accepted accounting principles. GAAP accounting standards offer uniformity in how companies report their financial performance.
GAAP
GAAP was developed by the Financial Accounting and Standards Board (FASB) to standardize financial reporting, providing a uniform set of rules and formats to facilitate analysis by investors and creditors. The GAAP created guidelines for item recognition, measurement, presentation and disclosure.
Bringing uniformity and objectivity to accounting improves the credibility and stability of corporate financial reporting, factors that are deemed necessary for optimally functioning capital markets. Companies can be compared against one another; results can be verified by reputable auditors, and investors can be assured that the reports are reflective of fundamental well-being. These principles were established and adapted largely to protect investors from misleading or dubious reporting.
Non-GAAP
There are instances in which GAAP reporting fails to accurately portray the operations of a business. Companies are allowed to display their own accounting figures, as long as they are disclosed as non-GAAP and provide reconciliation between the adjusted and regular results.
Non-GAAP figures usually exclude irregular or non-cash expenses, such as those related to acquisitions, restructuring or one-time balance sheet adjustments. This smooths out high earnings volatility that can result from temporary conditions, providing a clearer picture of the ongoing business.
Forward-looking statements are important because valuations are largely based on anticipated cash flows. However, non-GAAP figures are developed by the reporting company, so they may be subject to situations in which the incentives of shareholders and corporate management are not aligned.
MANIFEST 40 Return Forecasts. This comparison of generating return forecasts is based on Cash Flow (CF), Price-to-Cash Flow (P/CF) and GAAP vs. Non-GAAP earnings. For our most widely-followed stocks, the differences are not all that material although the GAAP forecasts tend to be slightly lower.
Model Behavior
When faced with a “debate” like this, it can be helpful to remember what outcome we’re aiming at. In the case of equity analysis, we’re leaning on historical data to build a vision, a future that we imagine, for the companies we study. Using earnings and P/E ratios means that any disruption in business model, capital structure or corporate portfolio could change relationships.
The flavor of earnings that form the foundation of our models and forecasts can make a difference — but we try to focus on continuing operations and de-emphasize historical data or events that deserve to be excluded.
In this case, we’ve stacked up our (often Non-GAAP) conditioned EPS-driven forecasts versus (1) cash flow-based forecasts that are unaffected by tax-driven adjustments and (2) GAAP-based forecasts.
Our conclusion, at least for our most widely-followed companies, is that GAAP vs. Non-GAAP is much ado about virtually nothing and that conditioned earnings generate return forecasts that are more consistent and reliable.
MANIFEST 40 Return Forecasts. The graphic shows the case-by-case results of using cash flow-based return forecast versus earnings (both Non-GAAP and GAAP). With few exceptions, the differences are relatively small or “not material.” In cases with more M&A activity, more diligence is prudent. Since cash flow-based analysis and forecasts are “immune” from the earnings disruptions giving some investors pause, we find it comforting that our analysis and forecasts tend to align more closely with the CF-based method used for nearly 100 years by the Value Line Investment Survey.
Mark Robertson
Mark Robertson is founder and managing partner of Manifest Investing, a source for research and portfolio management focusing on strategic long term investors.