We recently got some good news: After five consecutive quarters of decline, earnings growth returned to S&P 500 (^GSPC) companies. The earnings recession ended.
The resumption and acceleration of earnings growth is at the core of most experts’ bullish forecasts for the stock market.
But what if it’s all a big lie?
This relates to a matter that Yahoo Finance has been reporting on for a while.
Beware the “GAAP gap”
When accounting for business, CFOs are guided by a standard known as generally accepted accounting principles, or GAAP. GAAP represents an attempt to promote uniformity in how companies report their financial performance.
But income statements reported based on GAAP don’t always do a good job of reflecting the ongoing performance of a company’s underlying operations. GAAP earnings will include a lot of non-recurring or one-time items like asset write-downs and restructuring costs. These items distort quarterly profits and arguably misrepresent long-term profitability. And so, a company will also provide an adjusted, or non-GAAP earnings number that excludes what are arguably non-recurring items.
Unfortunately, non-GAAP earnings often reflect a lot of liberties taken by managers aiming to inflate their numbers.
“There are mixed opinions in the market about the use of non-GAAP EPS,” FactSet’s John Butters said on Friday.
“Supporters of the practice argue that it provides the market with a more accurate picture of earnings from the day-to-day operations of companies, as items that companies deem to be one-time events or non-operating in nature are typically excluded from the non-GAAP EPS numbers,” Butters continued. “Critics of the practice argue that there is no industry-standard definition of non-GAAP EPS, and companies can take advantage of the lack of standards to (more often than not) exclude items that have a negative impact on earnings to boost non-GAAP EPS.”
The magnitude of the gap between GAAP and non-GAAP earnings is illustrated starkly by the financial results of the Dow Jones Industrial Average (^DJI) during in Q3 earnings season.
“For the 21 companies in the DJIA that reported non-GAAP EPS for Q3 2016, the average non-GAAP EPS growth rate was 10.8%, while the median non-GAAP EPS growth rate was 5.1%,” Butters observed. “For these same 21 companies, the average GAAP EPS growth rate for Q3 2016 was -3.7%, while the median GAAP EPS growth rate for Q3 2016 was -1.2%.”
An important caveat from Butters: “The average difference between non-GAAP EPS and GAAP EPS for the DJIA was unusually large because of DuPont. For Q3 2016, DuPont reported non-GAAP EPS of $0.34 and reported GAAP EPS of $0.01.”