In his latest annual letter
to the shareholders of Berkshire Hathaway, Warren Buffett, “The Oracle of Omaha,” lambasted the use of accounting measures that don’t follow generally accepted accounting principles (GAAP), otherwise known as “earnings excluding bad stuff” (EEBS).
It’s true, however, that non-GAAP earnings often do exclude both bad and good stuff for sensible reasons. In any event, the financial media picked up on Buffett’s beef with “phony” earnings.
Here are a few of the headlines he made:
Is all the hubbub over non-GAAP reporting justified? Sure, but it may be overblown. US public companies are required to report earnings on a GAAP-basis to avoid misleading investors. Most analysts and investors are very aware of the pitfalls in relying solely on non-GAAP reporting. Melissa, Joe, and I have been working on this issue, which has been especially important in recent quarters, as write-offs and other items prone to exclusion from non-GAAP measures have increased significantly.
Consider the following:
(1) Buffett’s beef.
Here’s the Oracle’s main concern, as expressed in his 2015 letter released on February 27: “[I]t has become common for managers to tell their owners to ignore certain expense items that are all too real. … And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?
“Wall Street analysts often play their part in this charade, too, parroting the phony, compensation-ignoring ‘earnings’ figures fed them by managements. Maybe the offending analysts don’t know any better. Or maybe they fear losing ‘access’ to management. Or maybe they are cynical, telling themselves that since everyone else is playing the game, why shouldn’t they go along with it. Whatever their reasoning, these analysts are guilty of propagating misleading numbers that can deceive investors.”
(2) Nothing new.
This all sounds like a major exposé. However, it isn’t the first time that Buffett has expressed his concerns about EEBS. In his 1998 letter,
he wrote: “In effect, accounting principles offer management a choice: Pay employees in one form and count the cost, or pay them in another form and ignore the cost.” Of course, that was before the rules changed on expensing employee stock compensation back in December 2004. In his latest letter, however, Buffett said that he still has a problem with how companies tend to ignore stock-based compensation in “adjusted” earnings: “The very name says it all: ‘compensation.’ If compensation isn’t an expense, what is it?”
In his previous 2014 letter,
he noted that depreciation is a “real” cost and shouldn’t be excluded from results for most companies. “When CEOs tout EBITDA [earnings before interest, taxes, depreciation and amortization] as a valuation guide, wire them up for a polygraph test.” In his latest letter, he repeated the message: “When CEOs or investment bankers tout pre-depreciation figures such as EBITDA as a valuation guide, watch their noses lengthen while they speak.”
(3) Balanced view.
The Financial Accounting Standards Board (FASB) in Concepts Statement No. 8
states that the objective of general purpose financial reporting “is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity. … However, general purpose financial reports do not and cannot provide all of the information that existing and potential investors, lenders, and other creditors need. Those users need to consider pertinent information from other sources ….”
In other words, non-GAAP information may be useful to investors in some cases. That’s especially true when one-time nonrecurring events might make “real” results less meaningful for assessing underlying profitability.
In any case, the SEC’s rules protect against the overuse of such information in a way that might mislead investors. Registrants filing with the SEC, with a few exemptions, that disclose non-GAAP financial measures are required to also present the comparable GAAP measures and show a reconciliation between them. In addition, “for financial information to be understandable, users should have a reasonable degree of financial knowledge and a willingness to study the information with reasonable diligence,” according to FASB. That means it’s up to the users of financial statements to diligently study all the publicly available information provided by companies. (By the way, we’re required to note that the quoted FASB material is used with permission.)
(4) Oracle’s audience.
Buffett’s audience for the letter seems to be less savvy individual investors. He even says so: “We do not follow the common practice of talking one-on-one with large institutional investors or analysts, treating them instead as we do all other shareholders. There is no one more important to us than the shareholder of limited means who trusts us with a substantial portion of his savings.” In other words, he is doing all the accounting work on behalf of his shareholders. So they can rest easy that they are in good hands. Notice that he isn’t complaining that he doesn’t have the information he needs to make his investment decisions.
(5) Two sides.
Buffett wrote that Wall Street’s “sell-side” analysts are also engaged in the earnings “charade.” We all know that the job of most sell-side analysts is to sell investment ideas to generate trades as well as to attract investment banking business. Buy-side analysts are more likely to be paid based on the performance of their stock recommendations than sell-siders, according to a 2014 study
by Lawrence Brown (et al.) titled Skin in the Game: The Inputs and Incentives that Shape Buy-Side Analysts’ Stock Recommendations. Importantly, the study also found that buy-side analysts say recent 10-K or 10-Q reports tend to be more useful for decision making than quarterly conference calls, management earnings guidance, and recent earnings performance.
Contrary to Buffett’s recent contention, the study highlighted that most buy-siders say that “they never exclude depreciation expense, and more analysts say they never exclude stock option expense and amortization expense than say they always exclude these items.” More generally speaking, an analyst was quoted saying, “We’re more concerned with the core operations of the company and what’s going to happen over the next couple of years or so.” That’s as opposed to a quarterly beat or miss based on “adjusted” consensus-based earnings. Another analyst added, “We’re going to make [our own] adjustments that adhere to what we think the true earnings power of the business is.”
(6) Excluded items.
From a top-down perspective, Standard & Poor’s (S&P) compiles the S&P 500 reported earnings-per-share series on a quarterly basis. It is the GAAP measure. We track two versions of operating earnings, which are adjusted for both nonrecurring bad and good stuff. One is compiled by S&P, and the other is compiled by Thomson Reuters (TR). As we’ve noted before, the former is closer to GAAP because S&P is less generous than TR, which bases its numbers on the “majority rules” of sell-side industry analysts, who tend to accept the accounting guidance of the companies they follow.
During good times, operating and reported earnings tend to coincide. During bad times, there tend to be more excuses for poor results, so the former tends to exceed the latter. Last year, TR operating earnings totaled $118.13 per share, well above S&P operating earnings of $100.44, and S&P reported earnings of $86.53.
We put together a similar analysis of the 10 S&P 500 sectors comparing TR operating earnings to both S&P reported and operating earnings. The bottom line is that Energy, Materials, and Utilities had the biggest gaps between the two measures during Q4. Interestingly, TR operating earnings per share tends to consistently exceed SP’s operating and reported earnings per share in Consumer Staples, Health Care, and Information Technology. That might be mostly attributable to compensation paid with stock options.
Dr. Ed Yardeni
is the President of Yardeni Research, Inc., a provider of independent global investment strategy research. To read more of his blogs, CLICK HERE NOW.
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