Non-GAAP numbers refers to the use of adjusted earnings metrics to give a cleaner or more predictive measure of earnings. Now, companies describe non-GAAP metrics in a variety of ways. For example, they may refer to them as adjusted earnings, underlying earnings, core earnings, trading earnings, or even pro forma earnings. Also, they can apply adjustments to different profit measures. For example, EBITDA, EBIT and operating income, net income and EPS. Sometimes companies also adjust their reported cashflow numbers regardless of how these metrics are described and the profit measures that they're applied to. The common theme with non-GAAP metrics is that they are not covered by accounting rules. This gives management a large amount of discretion in the adjustments that they make and how these adjustments can change from one year to another. To help us assess the risk of bias in non-GAAP numbers, we can group and classify the typical adjustments made by companies, and we can do this as follows, the first type of adjustment that companies make is to adjust the accounting. This is where companies add back costs or add additional revenues because they believe this provides a superior measure of profits. Examples of this are where a company adds in equity method profits from JVs and associates into their EBIT, or where they add back stock option costs and pension costs on the basis that these are non-cash items. The next type of adjustment is to exclude non-recurring items. This is where companies add back non-recurring costs or deduct non-recurring revenues since it gives a cleaner profit measure. Examples of this are the add back of restructuring costs, litigation costs, and asset impairments. The next type of adjustment is to exclude M&A items. This is where companies adjust to exclude the effects of M&A accounting, for example, adding back the amortization of M&A intangibles, or adding back acquisition related expenses. The final category is excluding volatile items, for example, adjusting for FX or currency gains and losses from their earnings. Once we've classified the adjustments in this way, we can start to think about the risk associated with each adjustment and whether it could result in bias in the adjusted numbers. As you can see here, those on the left are considered high risk. Whilst those on the right are considered low risk, though not necessarily risk free. So why is this? Let's take each adjustment type. In turn, when companies adjust the accounting, there is a major risk that they're cherry-picking their adjustments simply to enhance their adjusted earnings. For example, including non-core earnings from Associates in EBIT is not consistent with how most analysts would treat income from associates, so this adjustment does not enhance our analysis. Also, there is no real justification for companies adding back non-cash costs, such as stock option charges and pension costs to a profit metric. Even though no cashflow may have occurred in this year, the expense reflects either a cashflow or some other transfer of value in future years. So it is still relevant for assessing performance when companies exclude non-recurring items. There is also a major risk of bias. For example, companies may add back costs, which are in fact recurring. Some companies seem to incur restructuring costs and litigation costs year after year, so it's really important to question the validity of these adjustments. Also, a further risk is that companies don't adjust for non-recurring gains, such as profits from asset disposals, and this can be extremely difficult to spot when companies exclude M&A accounting effects. Most analysts are comfortable with these adjustments as it helps us to compare companies which have grown organically with those that have grown through m and a. However, these adjustments are not risk-free. We still need to ensure that companies are not kitchens sinking. This relates to adjustments, including items which are not necessarily M&A related. For example, companies sometimes add back all intangible amortization to their adjusted earnings rather than just m and a related amortization, and this would be inappropriate when companies adjust for volatile items. This is usually considered an appropriate adjustment for most analysts and low risk. However, it is important to remember that a large volume of these adjustments do reflect a high exposure to either FX or currency risk.
