We See A Growing Use Of Adjusted Earningsi
In the past few years, the use of adjusted earnings has grown, creating potential pitfalls for investors. The use of adjusted earnings by S&P 500 companies grew from 208 companies in 2009 to 401 companies in 2015.ii Using companies’ adjusted (and more often flattering) earnings can be misleading.
Why Do We Think It Is An Issue?
1) Adjusted earnings can over state reality.
PWC, one of the Big Four accounting firms, stated that the way adjusted earnings are calculated can make them “susceptible to bias or misinterpretation”. One clear example is to look at the S&P 500. In 2015 reported S&P 500 earnings were $562 billion, while adjusted earnings were 43% higher at $804 billion. In 2015, S&P 500 reported earnings fell 15%, while adjusted earnings were flat.iii
2) They may ignore expenses that are real.
A good example of this is that adjusted earnings many times do not include stock based compensation. Warren Buffett stated in his 2015 annual letter, “Stock-based compensation is the most egregious example. The very name says it all: compensation. If compensation isn’t an expense, what is it?”iv
Facebook had earnings of $3.6 billion in 2015, but adjusted earnings of $6.5 billion, thanks in large part to $2.9 billion in compensation added back. And it is not just stock based compensation. Of 816 adjusted earnings surveyed by Calbench, 45% of adjustments were restructuring, 30% were acquisitions, and 20% were compensation related.v For example, in 2015, Merck earnings were $4.4 billion, but they reported adjusted earnings of $10.2 billion. Merck’s upward adjustment of 132% was made possible by taking out acquisition costs, restructuring costs, foreign exchange losses in Venezuela, and litigation costs. vi
3) When issues arise, adjustments can become a focal point.
When adjusted earnings are going up, they seem to be celebrated by investors. However, when a company runs into problems, they become a focus. In an academic literature review, studies found that investors seem to be more hesitant to use adjusted measures for their decision making after negative media attention.vii
One recent example is Valeant Pharmaceuticals. Their growth in adjusted earnings, in our view, was lauded as the stock appreciated. However, since Valeant has run into issues, their adjustments appear to have become more heavily scrutinized by investors, the media, and the SEC. According to Audit Analytics, companies that reported adjusted earnings are more likely to encounter some kind of accounting problems than those that adhere to strict measures.viii
Heavy use of adjusted earnings, followed by scrutiny, is nothing new. In the late 1990’s tech stock boom, adjustments were common. After the market crash, Congress told securities regulators to clean up disclosures. The result was Regulation G, which requires companies to explain the adjustments that they use.ix
SEC Potentially Getting Involved Again
The current chair of the SEC, Mary Jo White, stated in March 2016 that the commission may look at new regulations to “rein in” use of adjustments. However, we don’t believe rule changes are imminent, as Mary Jo White has announced that she will leave the commission at the end of the Obama administration.x
Anchor Capital Stays True To Its Conservative Approach
Anchor eschews the growing use of adjusted earnings. Instead we focus on the company’s non-adjusted earnings and, more importantly, its ability to consistently generate free cash flowxi that can be returned to investors. When calculating free cash flow, we add back real expenses such as stock based compensation. We believe that this is a more prudent, conservative way to value a business, and that this conservatism serves as an important factor in portfolio risk management.