What are “Non-GAAP Metrics”?
Non-GAAP metrics are performance measures reported by companies that are not defined by accounting standards. There are two key types of non-GAAP metric:
- Performance measures that are outside the scope of accounting standards. An example of this is EBITDA.
- Performance measures are covered by the accounting standards but where the company has chosen to amend how the measure is calculated. Examples of this include Adjusted Operating Profit and Underlying EPS.
Companies can describe non-GAAP earnings in a number of ways, the most common descriptions are: ‘adjusted’ earnings, ‘underlying’ earnings, ‘comparable’ earnings, ‘core’ earnings, and ‘recurring’ earnings.
Non-GAAP metrics are usually reported by companies when they believe that this measure provides a ‘truer’ measure of underlying performance and therefore a better predictor of future performance of the business.
Analysts often place a lot of emphasis on non-GAAP metrics as they are often considered more useful for financial analysis and valuation. However, non-GAAP metrics can be manipulated by management because they are not covered by accounting standards and are not subject to audit. Financial regulators, therefore, have rules in place which restrict how these metrics are disclosed, to prevent these metrics from being used to mislead investors. Non-GAAP metrics are therefore widely referenced in investor communications and are often included in the Management Discussion & Analysis (MD&A) section of the regulatory financial filings.
Key Learning Points
- Non-GAAP metrics are not covered by accounting standards; examples include EBITDA, Adjusted Operating Profit, and Underlying EPS
- Non-GAAP metrics are widely used by analysts as they are usually a better predictor of future earnings, but caution should be exercised as management has discretion over how they are calculated
- As Non-GAAP metrics are not covered by accounting standards, financial regulators have rules restricting how the metrics are disclosed
- If a company repeatedly reports non-GAAP earnings which are significantly higher than GAAP earnings, this can be viewed as a ‘red flag’ by investors
Disclosure of Non-GAAP Metrics
Although the use of non-GAAP metrics is optional, they are widely used by public companies in their communications with investors. They are often included in press releases and company presentations and are sometimes included in financial reports. When they are included in financial reports, they are usually found in the MD&A.
Financial regulators (including the SEC and ESMA) have rules in place which try to minimize the risk that non-GAAP metrics are being used to mislead investors. Although the detailed rules differ by region, the main requirements are:
- Companies must reconcile non-GAAP metrics to the nearest comparable GAAP metric (e.g. a reconciliation between Adjusted Operating Profit and Operating Profit). This should include a clear explanation of how the metric is calculated and any significant adjustments made by management;
- Companies must explain why the metric provides useful information to investors and how (or if) management uses this metric internally; and
- Where non-GAAP metrics are included in press releases and regulatory filings, these metrics cannot be given more prominence than GAAP metrics.
Below is an extract of a non-GAAP reconciliation included in the press release of a company’s full-year results:
Extract from Coca-Cola’s Full Year 2020 Results press release.
The following key points can be noted from the extract above:
– Non-GAAP operating income was $9,770m, whilst GAAP operating income was $8,997m
– Management has added back $238m of ‘asset impairments’. These are common adjustments as they are usually viewed as non-recurring expenses
– Management has added back $413m of ‘strategic realignment’ expenses and $99m of ‘productivity and reinvestment’ expenses. These appear to be another way of describing reorganization costs and these would typically be viewed as non-recurring expenses
– Management has added back $51m of ‘transaction losses’ and has deducted $28m of ‘other items’. Disclosures in the press release explain that these relate to fair value losses on contingent consideration and fair value gains on derivatives, and both of these would typically be viewed as non-recurring items
Analyzing Non-GAAP Metrics
Non-GAAP metrics provide us with useful insights into how management communicates with investors. If the adjustments made by management appear to lack justification or if the adjustments are simply not well disclosed, this could indicate that management is trying to manipulate how it reports ‘underlying’ performance.
Below is a multiple-choice question to test your knowledge of non-GAAP metrics. Download the accompanying excel exercise sheet for a full explanation of the correct answer.