“many companies – including all of the 25 largest US-based nonfinancial companies—are increasingly reporting some form of non-GAAP earnings.”
-McKinsey & Company-
What is the reason so many companies are using these Non-GAAP metrics? Could it be we now live in a world that every company is so unique that they must use these figures to fully express their financials OR is it a way that companies are diluting their financials to mislead investors? Below you’ll find the perspectives of investors, regulators, and companies to help you further understand the controversial subject of non-GAAP financial metrics.
It appears most analysts (76%) are using non-GAAP performance measures in their own analyses. The most common non-GAAP measures used by investors today are:
- Adjusted revenue
- Adjusted net income
- Adjusted EBITDA
- Adjusted EPS
- Free cash flow
- Funds from operations (FFO)
- Same Store Sales
- Average revenue per customer
- Sales per square foot
There’s often no apples to apples comparison using these measures for analysts. This is because there currently is no non-GAAP accepted standard for what is used to calculate. It can be argued that information no matter how comparable or biased can still give investors a better understanding of a company’s performance.
In a survey, CFApubs.com concluded that “NGFM are useful for investors who apply them for varied reasons, including as a valuation input and as an indicator of accounting quality.” They go on to say they are used “to a less extent than GAAP/IFRS measures” and “most investors who use NGFMs make further adjustments to arrive at their version of economically relevant measure.” Investors feel a higher risk when using Non-GAAP metrics and look to the regulators (SEC, IOSCO, and ESMA) to crack down on companies to make these metrics more reliable.
15 years ago, the Enron scandal initiated the SEC to create rules for non-GAAP metrics. Recently the Securities and Exchange Commission has again put special focus on Non-GAAP metrics. In 2016 the SEC’s Division of Corporation Finance issued a revised set of compliance and Disclosure Interpretations (CDIs) followed by comment letters and speeches on the topic. SEC Chair Mary Jo White said in one speech, “In too many cases, the non-GAAP information, which is meant to supplement the GAAP information, has become the key message to investors, crowding out and effectively supplanting the GAAP presentation.”
There have been over 200 comment letters sent out by the SEC pertaining to non-GAAP metrics including ones to Tesla Motors Inc. After conversing with the SEC, the company has publicly said they would drop the non-GAAP revenue and other custom metrics that the letters pointed out.
Below are the percentages of topics the SEC has sent out comment letters about non-GAAP as of 10/4/2016:
In addition to the comment letters the SEC has adopted new rules focused on NGFM including:
- A new disclosure regulation, Regulation G
- Amendment to Item 10 of Regulation S-K
- Amendment to Item 10 of Regulation S-B
To read about more about this, see the SEC’s Final Rule on the matter.
Some companies defend using Non-GAAP figures saying that they are painting a clearer picture of their underlying business. They point out that the GAAP standards have many flaws and believe they are showing the math of how they arrive at the figures that th?e SEC requires. Gretchen Morgenson in his New York Times Article counters this argument by saying “Companies, if granted the leeway, will surely present their financial results in the best possible light. And of course they will try to persuade investors that the calculations they prefer, in which certain costs are excluded, best represent the reality in their operations”. Examples of how Non-GAAP metrics can make a company look more appealing is shown by the below bar graph provided by bloomberg.com:
Overall investors want more information, the regulators are keeping an eye on the quality of that information, and companies want investors to see them in the best possible light while keeping the regulators happy. This is not a black and white topic and, in fact, it will most likely continue to be in flux.