Non-GAAP Earnings: Definition and How They Work in Analysis
Non-GAAP earnings are alternative, company‑reported measures of profitability that adjust or exclude items from the standard GAAP (Generally Accepted Accounting Principles) results. Companies present these pro forma figures to highlight what they consider the performance of core operations by removing one‑time or nonrecurring items such as asset write‑downs, restructuring charges, or large gains/losses.
Common Non‑GAAP Measures
- EBIT — earnings before interest and taxes
- EBITDA — earnings before interest, taxes, depreciation, and amortization
- Adjusted revenues or adjusted EPS — excludes specified items the company deems nonrecurring
- Free cash flow, core earnings, funds from operations (FFO)
Why Companies Use Non‑GAAP Measures
- To present a view of ongoing operating performance without unusual or nonoperational events
- To provide supplementary information that management believes is more representative of earning power or cash generation
Key Risks and Criticisms
- Lack of standardization: Non‑GAAP measures are not governed by a single set of rules, so definitions and adjustments vary by company.
- Potential for manipulation: Companies can exclude items that reduce GAAP earnings repeatedly, turning so‑called “one‑time” adjustments into routine practice.
- Overemphasis: Placing greater prominence on non‑GAAP results can mislead investors if GAAP figures are downplayed.
- Non‑GAAP EPS is especially vulnerable since there’s no uniform definition; headlines based on adjusted EPS can influence market reactions.
Example: In Q4 2017, one company converted a GAAP loss per share into a substantially larger adjusted profit per share, illustrating how large the differences can be.
Regulatory Guidance
Regulators require GAAP reporting for consistency and comparability. The SEC has pushed companies to present GAAP figures prominently and has taken enforcement actions when non‑GAAP measures are emphasized improperly. Technology firms are often noted for frequent use of non‑GAAP adjustments because of stock‑based compensation, R&D expenses, and asset impairments.
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How to Evaluate Non‑GAAP Earnings (Checklist)
- Require reconciliation: Look for a clear reconciliation between GAAP and non‑GAAP figures in the company’s filings.
- Question the exclusions: Ask whether excluded items are truly nonrecurring or are likely to recur.
- Check consistency: Prefer measures that are defined and applied consistently across reporting periods.
- Compare to cash flows: Non‑GAAP earnings that diverge significantly from operating cash flow merit closer scrutiny.
- Use peer comparisons: Ensure adjustments are comparable across companies in the same industry.
- Read disclosures: Review footnotes and management commentary to understand the rationale for adjustments.
Takeaway
Non‑GAAP earnings can provide useful supplemental insight into a company’s operating performance when used carefully. They should not replace GAAP results; instead, treat non‑GAAP metrics as a complement, verify reconciliations and consistency, and remain skeptical of repeated “one‑time” exclusions.