Risk & Compliance

Investors Speak: Down With GAAP!

Non-GAAP metrics command far more attention from investors than do the official numbers, new research shows.
David McCannDecember 18, 2017
Investors Speak: Down With GAAP!

Will there come a time when accounting regulators bow to the inevitable and finally acknowledge that generally accepted accounting principles (GAAP) have lost a great deal of their relevance?

Surely, if accounting were being invented today, it would look a lot different than it does.

After the Securities and Exchange Commission issued new guidance on the use of non-GAAP metrics in May 2016, investor relations advisory and services firm Clermont Partners observed increasing consternation among its corporate clients, said Clermont founder Elizabeth Saunders during a recent webinar.

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

Although guidance is intended to make regulations clearer, last year’s pronouncements, combined with the SEC’s increasingly rigorous enforcement around the issue, left companies confused as to what non-GAAP measures they could use and talk about.

Even more pronounced was their frustration that in so many cases the official numbers provided less insight into a company’s performance than the unofficial ones.

Clermont’s buy-side contacts had similar feelings, Saunders said. So the firm decided to survey buy-siders on the topic to find out just how deep their discontent runs and whether they think about the use of non-GAAP metrics as rigorously as the SEC wants.

Clermont identified and sent surveys to 580 U.S.-based, actively managed buy-side investment funds and firms (excluding actively managed exchange-traded funds) with more than $200 million in assets under management. Almost 10% (56) of them responded.

The centerpiece, eye-opening result, although Saunders characterized it as unsurprising, was that 74% of the participants said they rely more on non-GAAP metrics than on GAAP in performing their analyses. Also, only 36% of them agreed with the statement, “GAAP presentations of financial statements provide an accurate picture of a company’s financial performance.”

And exactly 9 in 10 respondents said they carve out their own view of a company’s financials to some degree by making adjustments to GAAP numbers.

“It’s interesting how many times we heard things like, ‘GAAP means nothing to me, I completely ignore it because of all the non-recurring adjustments,’” said Saunders.

Decline and Fall

Clermont hosted the webinar, whose other panelists were Christopher Marangi, a portfolio manager at investment firm Gamco; Elizabeth Lilly, founder and president of Crocus Hill Partners, an investment firm specializing in small-cap equities; and Baruch Lev, professor of accounting and finance at New York University’s Stern School of Business.

Lev presented findings from a research study he co-authored showing that in the years just before and after 1990, a “perfect” investor — a hypothetical one who could predict every public company that would meet or beat analysts’ consensus GAAP earnings estimates — would earn a quarterly return of just under 6%. That number has generally been declining ever since, reaching 2% by 2015.

The conclusion: GAAP earnings “no longer reflect what they should reflect,” said Lev.

Lev also noted that until the mid-1980s, there was a strong correlation between two GAAP metrics: earnings and book value. Since then, the relationship has consistently declined. That trend has coincided with decreasing investment in tangible assets — property, plants, equipment — and increasing investment in intangible assets: R&D, patents, brands, information systems.

That growing gap “correlates well with the demise in the value of GAAP information,” Lev said. “All those huge investments are basically expensed in the income statement [along with] regular expenses like salaries, interest, and rent, which completely destroys the income statement and, of course, the balance sheet.”

Lev has been talking about the diminishing value of GAAP for years and co-authored a book on the topic, “The End of Accounting” (Wiley, 2016). He and co-author Feng Gu examined hundreds of conference calls in order to more fully understand what was important to investors. What they found was that investors placed the most value on what economists call “strategic assets” — ones that are unique to a company.

When it comes to discussions of non-GAAP metrics, most of the focus typically is on earnings measures — EBITDA, adjusted EBITDA, adjusted net income, adjusted EPS — as well as free cash flow and enterprise value, Lev noted. But information on strategic assets is more important, he stressed.

He embellished his thoughts in an interview with CFO. The number of industries providing good, comprehensive information on such assets is growing fast, he said. Currently, the group includes pharma/biotech (product pipeline data); Internet service providers, telecom, and media (customer data); oil and gas (information on exploration and renewals); insurance (policy renewal, frequency, and severity of claims); and retail (same-store-sales).

Just a few years ago, Lev said, during a consulting engagement he advised a pharmaceutical company that it should disclose complete information on its product pipeline in order to entice investors. “They said, ‘Are you crazy?’”

Not that there isn’t much room for improvement. “It’s good disclosure but often inconsistent from year to year and not very easy to find,” he told CFO.

For Marangi, the decline of GAAP “has been an evolution over many decades as the nature of the economy has changed and the financial sector has gotten larger and more sophisticated,” he says. “There are more financial professionals with more data that are trying to get an edge on one another.”

But, he said, no matter what data is used, the value of a company comes down to the present value of future cash flows. “When we look at a company today we’re really asking three questions: What is its true cash-flow power today? How fast will that cash flow grow? And how predictable and defensible is the cash flow? And those questions are primarily informed by non-GAAP measures.”

Lilly said her firm conducts very detailed reviews of companies’ financial statements, including footnotes, to establish whether those audited metrics correspond with what they’re portraying in their non-GAAP metrics. “The more correlated they are, the more comfortable we are,” she said.

She added that it’s crucial for analysts to “do the math themselves” and to determine what expenses are truly non-recurring or otherwise extraordinary. Companies are “not always forthright” in their non-GAAP earnings measures, she said. If they were, she pointed out, the non-GAAP figures would not, as is almost always the case, be higher than the GAAP numbers.

Lilly criticized companies, of which there are many, that drop stock-based compensation expense in calculating non-GAAP earnings. “It’s an outlay of company shares that dilutes the ownership of other shareholders,” she said. “It is a real expense.”

Additionally, Lilly said her firm is “very leery” of serial acquirers that eliminate acquisition expenses in their non-GAAP reporting. These companies often do, however, include the revenue added from acquisitions. “You never truly understand what the ongoing earnings of these companies are,” she said.

She also railed against the SEC for failing to provide clear-cut rules for including or excluding expense items in non-GAAP presentations. “What companies adjust for in their non-GAAP calculations gives true insight into how they view themselves,” she said. “Are they using the non-GAAP measures to help people truly understand the business? Or are they trying to improve the way investors perceive the business?”

The best measure for purposes of valuing companies, Lilly said, “is somewhere between GAAP and non-GAAP, because non-GAAP can overstate earnings and GAAP can understate earnings.”