Rise in upward earnings adjustments is a worrying trend

To adjust or not to adjust? That’s the key question for companies when presenting their accounts. There’s been an increasing tendency for companies to focus on adjusted ‘non-GAAP’ (Generally Accepted Accounting Principles basis) numbers instead of the more regulated GAAP numbers. My colleague Simon Bailey highlighted this in his blog in January – ‘An easy way to boost profits – ignore costs!’.

I did some further analysis drilling down to the company level to see if accounting adjustments occur more frequently in value or growth companies and also in which sectors. I used the US indices, the Russell 1000 Value index and the Russell 1000 Growth index, in my analysis.

The following (left hand) chart shows the percentage of companies in each index making upward adjustments each year. I found that growth companies are more likely to make upwards earnings adjustments than the value companies. That doesn’t mean value companies are bathed in glory though since overall, the percentage of companies adjusting upwards has grown steadily over the past six years. Upward adjustments are just not as prevalent amongst value companies. From a sector perspective (right hand chart), IT companies are persistent offenders, which is partly due to the high level of stock options in their remuneration. Healthcare and consumer staples, both sectors typically considered as defensive and more recently trading on elevated valuations, had over 60% of companies making upward adjustments in 2015.

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Why does it matter that companies are trying to inflate their earnings by making these adjustments? Some argue that they are made to give a clearer picture of the ongoing profitability of a business.

I’m a firm believer in GAAP representation of a company’s earnings because over the long term, GAAP earnings provide the true profit picture of a company and more importantly, are correlated with shareholder returns. The following chart from Société Générale shows GAAP and pro forma (adjusted) earnings of the S&P 500 plotted against the returns of the index. What this shows us is that shareholder returns are most closely correlated with GAAP earnings and that these are unfortunately currently falling in the US. The increasing levels of adjustments are disguising this point as forward market earnings are typically based on non-GAAP forecasts, masking the true underlying valuation of the market. That is a worrying trend.

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The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.