What Are Non‑GAAP Earnings?
Non‑GAAP earnings are alternative, company‑reported measures of profitability that adjust or exclude items reported under Generally Accepted Accounting Principles (GAAP). Companies publish non‑GAAP figures alongside GAAP results to try to show “core” operating performance by removing items management considers nonrecurring, noncash, or not reflective of ongoing business. Common non‑GAAP measures include EBITDA, adjusted EPS, adjusted revenues, free cash flow, and “core” earnings.
Source: Investopedia overview on non‑GAAP earnings (https://www.investopedia.com/terms/n/non-gaap-earnings.asp).
Why companies report non‑GAAP numbers
– To focus investors on recurring operating results by excluding: asset write‑downs, restructuring charges, acquisition expenses, stock‑based compensation, litigation settlements, or large one‑time tax items.
– To show performance metrics widely used by equity analysts and private markets (e.g., EBITDA used for valuation multiples).
– To supplement GAAP results with additional context — but not to replace GAAP.
Key benefits
– Can clarify cash profitability (e.g., adding back noncash depreciation/amortization).
– May better reflect management’s view of ongoing performance if adjustments are reasonable and explained.
– Helpful for cross‑period or cross‑company comparisons when standardized appropriately.
Key criticisms and risks
– Lack of standardization: there is no single governing body that defines most non‑GAAP metrics, so companies can define them differently.
– Potential for abuse: companies may exclude recurring or economically relevant costs to inflate “adjusted” profit. Studies show adjustments more often exclude losses than gains.
– “One‑time” items can become recurring: frequent exclusions that repeat quarter‑to‑quarter undermine their stated nonrecurrence. Example: Merck reported GAAP loss of −$0.02 per share but an “adjusted” profit of $1.11 per share in Q4 2017 after adjustments — a dramatic divergence that illustrates potential for misleading presentation.
– Prominence issues: a company can give non‑GAAP measures greater prominence than GAAP results in press releases or headlines, potentially misleading investors. The SEC requires GAAP measures to be presented and reconciled to non‑GAAP measures when publicly disclosed.
Common exclusions (some legitimate, some questionable)
– Legitimate or commonly accepted: depreciation & amortization (for EBITDA), certain noncash impairments when truly one‑time, acquisition‑related purchase accounting that won’t recur in same form, restructuring charges from a discrete program.
– Often questionable or that require scrutiny: recurring stock‑based compensation (can be substantial for tech firms), repeatedly excluded legal costs, routine acquisition amortization presented as “nonrecurring,” frequent tax adjustments, or excluding normal costs of doing business.
Regulatory context (brief)
– Public companies must present GAAP results in SEC filings. When presenting non‑GAAP measures publicly, companies are generally required to reconcile the non‑GAAP measure to the most directly comparable GAAP measure and to explain why management believes the non‑GAAP measure provides useful information. The SEC has taken enforcement actions where non‑GAAP measures are used in a misleading way or given greater prominence than GAAP results.
How to read and evaluate non‑GAAP earnings — practical steps for investors
1. Start with GAAP as your baseline
– Use GAAP earnings and cash flows as the foundation. Non‑GAAP is supplementary — not a substitute.
2. Inspect the reconciliation
– Every public disclosure of a non‑GAAP measure should include a reconciliation to GAAP. Verify the arithmetic and that the reconciled GAAP line is the “most directly comparable” GAAP metric.
3. Ask what’s being excluded and why
– Is the excluded item truly one‑time, unusual, or noncash? Or is it a recurring cost that should be part of ongoing results (e.g., stock comp for a tech company)?
– Look for precise descriptions (amount, nature, period). Vague language is a red flag.
4. Check frequency of the adjustment
– If an item is excluded in many periods, it’s likely recurring. Frequent “one‑time” exclusions undermine credibility.
5. Quantify the impact
– Calculate how large the adjustments are relative to GAAP earnings and revenue. Large adjustments materially change the story and demand scrutiny.
6. Compare across peers
– See how peer companies define similar measures. Lack of comparability reduces the usefulness of non‑GAAP metrics for valuation.
7. Translate to your model
– If you use non‑GAAP numbers, maintain your own consistent definition and adjust historical data so comparisons are apples‑to‑apples.
8. Prefer cash‑based metrics
– Cash flow measures (operating cash flow, free cash flow) are harder to manipulate with accounting adjustments than earnings.
9. Watch management discussion
– Read MD&A (management’s discussion) for the rationale behind adjustments and for forward‑looking statements that rely on non‑GAAP figures.
10. Use red‑flag checklist
– Red flags include: repeated exclusion of the same item, exclusion of routine costs (stock comp, recurring litigation), giving non‑GAAP more prominence than GAAP in press releases, lack of detailed reconciliation, or adjustments that convert GAAP losses into non‑GAAP profits.
How to reconcile non‑GAAP to GAAP — practical steps
1. Identify the most directly comparable GAAP measure (e.g., GAAP net income if company reports adjusted net income or adjusted EPS).
2. List each adjustment the company makes (e.g., add back: stock‑based compensation $X; restructuring charges $Y; amortization of intangible assets $Z).
3. Verify the numeric reconciliation (GAAP measure plus/minus adjustments = non‑GAAP measure).
4. Confirm whether adjustments are: noncash, truly nonrecurring, or related to core operations. Classify them for future modeling.
5. If a company omits a reconciliation in a press release, look for the reconciliation in the 8‑K, 10‑Q, or investor supplement — or contact IR for clarification.
Practical steps for companies (best practices)
– Present GAAP measures prominently and first.
– Provide clear, quantitative reconciliations with line‑item descriptions and footnote explanations.
– Limit exclusions to items that are demonstrably unusual, infrequent, or noncash.
– Be consistent in definitions period to period; disclose any change and the reason.
– Avoid giving non‑GAAP measures greater prominence in press releases, earnings headlines, or marketing materials.
– Follow SEC guidance and Regulation G requirements (reconciliation and explanation).
Examples of widely used non‑GAAP metrics and what they mean
– EBITDA = Net income + Interest + Taxes + Depreciation + Amortization. Useful for comparing operating profitability before capital structure and noncash charges, but ignores capital expenditure needs and working capital.
– Adjusted EPS = GAAP EPS adjusted for specified items (stock comp, restructuring, impairments, etc.). Useful only if adjustments are transparent and justified.
– Free Cash Flow = Operating cash flow − Capital expenditures. Focuses on cash available for debt servicing, reinvestment, dividends, or buybacks.
Red flags: sample investor questions to management or IR
– “Which items did you exclude this quarter and why do you consider them nonrecurring?”
– “How often have you excluded this type of item over the past three years?”
– “Can you provide a side‑by‑side reconciliation and show the cash impact of these adjustments?”
– “Why do you exclude stock compensation (or other recurring expense) — how does that reflect ongoing economics?”
– “How are non‑GAAP measures used by management internally (bonus metrics, forecasts)?”
Summary and practical advice
– Treat GAAP as the canonical accounting result; use non‑GAAP metrics only as complementary tools when their adjustments are transparent, reasonable, and economically meaningful.
– Always check reconciliations, quantify the impact of adjustments, and be skeptical of frequent “one‑time” exclusions.
– Where possible, rely on cash flow and standardized GAAP measures for valuation and comparability.
– If a company’s non‑GAAP presentation materially changes your view of performance, investigate the adjustments and consider building your own adjusted metrics with documented, consistent rules.
Further reading and references
– Investopedia: “Non‑GAAP Earnings” (source provided) — overview and criticisms. https://www.investopedia.com/terms/n/non-gaap-earnings.asp
– U.S. Securities and Exchange Commission (SEC) guidance and Regulation G — for rules and guidance on presenting non‑GAAP financial measures (see the SEC website for interpretive releases and enforcement actions).
If you’d like, I can:
– Review an earnings release (paste the non‑GAAP reconciliation) and flag questionable adjustments; or
– Build a simple spreadsheet template to reconcile non‑GAAP adjusted EPS to GAAP EPS and quantify recurring vs nonrecurring items.