As everyone knows, corporate earnings today commonly include two bottom lines: Companies report net income and EPS under Generally Accepted Accounting Principles, and then there’s a second number on the street that takes out one-time items. These metrics are commonly called GAAP earnings and “operating earnings,” without one-offs.
Over the years the gap between these two numbers has been growing, so that operating earnings for the S&P 500 have averaged nearly 24% higher than GAAP earnings in recent years, says a column (“Investors, It Pays to Mind the GAAP Gaps”) Friday in the Money & Investing section of The Wall Street Journal.
Says the Journal:
It isn’t clear why the difference has grown so wide. One inescapable conclusion is that, since 1995, either by happy accident or accounting shenanigans, one-time losses have grown more quickly than one-time gains, elevating the operating earnings that Wall Street watches.
Investors have mixed feelings about excluding one-offs from earnings. When you throw in EBITDA or adjusted EBITDA, which proponents in some industries prefer as a tool for valuation, some investors are confused or skeptical. You may have heard unconvinced accounting profs push back on “Earnings Before All the Bad Stuff.”
The Journal observes that companies tend to label negative events (write-downs or special charges) as one-offs more often than happy events (windfalls or gains on assets), and excessive write-offs may signal deeper problems:
Investors are well advised to watch both figures for another reason: Some companies have bigger differences between GAAP and operating earnings than others. According to research by Société Générale quantitative strategist Andrew Lapthorne, those with bigger gaps tend to underperform in the long run.
An interesting cautionary note, that bit about underperforming long-term.
Companies need to be careful that one-time accounting items and adjustments do help investors understand the business realities. Inflation in the gap between as-reported and “operating” earnings raises questions. For IR professionals, clarity in reporting (including consistent accounting approaches) should be the goal.