How to Use Non-GAAP Reporting and Make Better Investment Choices
We’re halfway through earnings season, and more data is still flooding into the market. Analysts and investors are combing through press releases and listening to earnings calls. And stock prices are moving based on the findings.
What you might not know is companies are releasing two different types of data.
One set of data is known as GAAP. It stands for generally accepted accounting principles and is the standard for financial reporting by US public companies. It was created by the Financial Accounting Standards Board (FASB) and is governed by the US Securities and Exchange Commission (SEC).
The other set is non-GAAP. These figures do not include nonrecurring or non-cash expenses. Eliminating nonrecurring charges can be used to make the numbers look better. One of the most commonly used non-GAAP financial measures is EBITDA, or earnings before interest, taxes, depreciation, and amortization.
Although not the standard, non-GAAP numbers are still monitored by the SEC. The agency has a history of taking action against companies that aggressively use non-GAAP numbers.
Companies are required to use GAAP for financial reporting. They can opt to also report non-GAAP to show what they consider more accurate performance results. GAAP lets investors compare company results because they all conform to the same standard. Comparing companies would be nearly impossible if each one used its own accounting system.
I go through 25‒30 sets of company data in a typical earnings season. This includes reviewing both press releases and earnings call transcripts in order to get management’s commentary. And when I’m doing this, I always look at both GAAP and non-GAAP numbers.
I’ve learned that GAAP doesn’t always give you the full picture, and that’s where non-GAAP numbers come into play.
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A Perfect Example of GAAP vs. Non-GAAP
The price-to-earnings ratio (P/E) is one of those valuation measures used to gauge if a stock is trading at a good price. It can be calculated on historical data or on forward looking (FWD) estimates. It’s the relationship between the stock price and company earnings.
I get asked a lot for my opinion on a company’s trailing 12-month (TTM) P/E. This is what you usually find on Yahoo Finance or other stock quote providers.
Let’s look at AbbVie’s (ABBV) current P/E numbers. I am frequently asked about this Dividend King because of its P/E of 63 shown on most data sites.
A P/E of 63 wouldn’t be out of the ordinary if we were talking about a tech company. Both Tesla (TSLA) and Nvidia (NVDA) have a P/E of around 60. Companies like these trade at higher valuations because investors expect earnings to grow quickly. Think about it. A P/E of 60 means you’re paying for 60 years of earnings for that stock today.
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ABBV is a completely different type of company. Yes, we’ll continue to see growth from its new therapies, but it’s not a typical growth-phase company. ABBV’s 63 P/E is based on GAAP (TTM) earnings.
Source: SeekingAlpha (Click to enlarge)
The table above shows TTM and FWD P/E using both GAAP and non-GAAP reporting. The GAAP TTM P/E looks scary, but the others are in line with the sector median. The large spread between the GAAP TTM and FWD P/E tells us that something uncommon probably happened during the past year. And we can assume it was non-recurring expenses.
A Bridge Between the GAAPs
If a company reports non-GAAP numbers it will usually include a reconciliation. Here’s a snippet from ABBV’s second-quarter earnings report:
Source: AbbVie (Click to enlarge)
The P/E ratio is simple math: divide the stock price by the earnings per share (EPS). The table shows the diluted EPS are much lower for GAAP than for non-GAAP. A lower EPS number will give you a much higher P/E for the same stock price.
The GAAP earnings number is lower because it includes non-recurring expenses. Keep in mind these numbers are for a single quarter, and the 63 P/E above is based on TTM. So, the difference between the GAAP and non-GAAP P/E reflects non-recurring charges for the past four quarters.
The reconciliation includes other information that explains what the adjustments are for the non-GAAP version.
Since GAAP is the standard, it’s useful for side-by-side company comparisons. But for me, the more data, the better. Make sure you’re not just looking at numbers in a bubble. Compare data that paints a more complete picture so you can make informed investing decisions through earnings season.
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Kelly Green
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