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- Don D., California
Pro Forma (Adjusted Earnings) Versus GAAP
What An Investor Needs To Know When Looking At The Value Line Page
Not all earnings are created equal. In fact, relying on company press releases can often lead investors astray in their understanding of a corporation’s true earnings picture. That’s where adjusting for nonrecurring items can help determine a stock’s underlying fundamental strength, and thus lead to more informed investment decisions.
Interpreting Earnings Reports
When comparing different companies against each other, potential investors can run into a number of hazards. One such obstacle is the fact that corporations often have different ways of presenting their respective financial results, even if they’re in the same line of business. To be sure, all publicly traded entities are required to file their reports to the SEC in accordance with Generally Accepted Accounting Principles, or GAAP. GAAP was set up by the Financial Accounting Standards Board (known as FASB to its friends) in order to create a more level playing field in terms of financial reporting.
But, even within the GAAP framework, there’s some leeway on how earnings can be presented to the public. Further complicating matters is the relatively recent phenomena whereby companies will include alternate methods for calculating earnings in their press releases. These are often referred to as “Pro Forma”, “operating”, “adjusted”, or “core” earnings. In essence, it’s supposed to be what a company earns from its ongoing business. That is to say, the impact from any ancillary events that management believes should not be considered part of “business as usual” will be removed, despite their ultimate effect on profits.
These are generally nonrecurring events, in many cases with negative effects on the bottom line. For example, if a company just built a new plant it might have significant startup costs to expense. Or, if it’s undertaking a large restructuring, there will be plant closure and severance expenses. Other scenarios could include a big tax break or fee, gains or losses on the sale of assets, costs to search for a new CEO, a change in accounting principles, unusual options expenses, early or late debt repayment, asset impairments, and mark-to-market changes in investments, among others.
Unfortunately, there’s no standard definition for what should and should not be included or excluded. Moreover, some items are relatively easy to take out because they are clearly spelled out in the company’s income statement or footnotes. Others, however, need to be based on estimates.
As such, this sometimes makes it challenging for investors to make a reasonable comparison of core operating results from one year to the next, or from one company to another. That’s where the Value Line page helps to arrive at a more common view, making comparisons more meaningful, direct and accurate.
Adjusting For Bias And Spin
Naturally, every company wants to present itself in the most favorable light possible, emphasizing the positives and downplaying the negatives. But too many times, it will often sound like the company is pretty much saying. “Well, we would have made all this money, if….all the following things hadn’t happened.” At times, a company will simply not want to highlight an expense, perhaps because it sheds a poor light on the business or management. This might include product recalls or litigation costs for cases that were eventually lost.
Meanwhile, the other side of the coin also holds true, in that companies will sometimes include one-time gains from activities that really don’t fit within the context of its business description. One example would be profits from sales of investment securities.
Another part of the problem for investors in cutting through the noise is that although these items may not occur every year, they are often a part of normal business operations. Some confusion arises when these nonrecurring items become persistently common, such as when a companywide restructuring stretches beyond one or two years and starts to become a decade long quest. In this case, the exception might be where a company usually takes small charges (which we’ll leave in), but now and then takes on a more significant project, which will be excluded.
One example would be Illinois Tool Works (ITW), a diversified manufacturer of components used by numerous industries. It has long been a key part of that company’s strategy to buy up relatively small businesses, get them into shape, and fold them into their existing mix. The company has been doing this for years, and it includes the associated restructuring charges in its reported earnings.
Another more or less universal example ties into the recent recession. For instance, a number of companies had been tightening their belts for a couple of years before the downturn hit, either for competitive reasons or out of necessity. Others may not have felt compelled to follow suit, but did so when conditions became threatening, and, in many cases, continue to trim costs. This is a situation where what used to be a relatively infrequent occurrence has become more commonplace.
The Value Line Page
It’s Value Line convention to exclude what we consider to be unusual or one-time gains and losses when they are traditional one-offs and not part of the company’s true day-to-day business, in order to show what we consider to be “normal” earnings. For every stock we cover, we indicate the nature of the adjustments to our earnings presentation, footnoted at the bottom of the page by year, either as net charges/losses or gains that we are including or excluding. As noted before, this will sometimes vary from company to company, so it’s important to check here before drawing conclusions.
There are some cases where activities are not really core to earnings, but are done regularly enough to be considered part and parcel of what it means to be in that industry, so we include them. For example, a company may be in the assisted living business (such as Sunrise Senior Living (SRZ)), or the retail sector (such as Sears Holdings (SHLD), but regularly records gains or losses from property sales. Another might be a paper or forest products company, such as Plum Creek Timber (PCL) or International Paper (IP), that every now and then builds up its cash holdings by selling forest acreage it no longer deems to be strategically important.
The Bottom Line On The Bottom Line
Reliable numbers are needed in order to evaluate a company and its management and thus make sounder investment decisions. The value of excluding nonrecurring items is that it provides a more accurate picture of a company’s true earning power, and can make for more direct comparisons with past performance and other companies within a specific industry. This is why Value Line takes the extra steps to dig into the numbers and do the work of adjusting reported earnings for our subscribers.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.