Previously, I wrote about “Which Valuation Matters?” and a key input in most valuations is what the company has earned. With the increasing abstraction of International Financial Reporting Standards (IFRS) and many management teams publishing their own “versions” of earnings (so-called “adjusted”, “normalized”, “core” or “underlying”, et al earnings), the next logical question is: what earnings figure matters?
Excluding the USA markets (which uses “GAAP”), IFRS allows global comparison between different companies, as well as a comparison with a company’s own history. This valuable context for investor decision-making could only be obtained by standardized rules (i.e. one size fits all).
As with most things in life, though, “one size fits all” does not, in fact, suit everyone.
The long-term trend in IFRS rules changes is towards fairly valuing balance sheets at the expense of income statements. However noble IFRS’ intentions may be, the result of this rules drift is that more and more adjustments unrelated to day-to-day business and operations are being forced through a company’s profit and loss. And, thus, overtime, many IFRS earnings reports are becoming increasingly meaningless to investors.
The logic solution has been for management to publish—along with their legally obliged IFRS financials—their own alternative earnings figure(s).
Any earnings figure that is not a fully, completely and unadulteratedly an IFRS term is, by definition, not an IFRS number. Because that figure is not an IFRS number, it could thus be anything management want it to be, despite what pretty name they have given it. It also may not be comparable to another company that has published an adjusted earnings figure despite using the same creative name. Also, and more subtly, the manipulated earnings figure may not even be comparable to the same company’s last year’s earnings as management may have changed how they calculate it (a massive investor red-flag if you find this!).
With no rules, no consistency, and—in some cases—no logic, these management-disclosed alternative earnings metrics are the Wild West of financial reporting and create as many problems as they solve.
The obvious problem is that there is no consistency. This makes this article difficult to write as each alternative earnings metric must be evaluated on its own. Thus, let me offer a guideline to use when evaluating these alternative earnings metrics and deciding how legitimate they are:
- No recon, no trust: If management either don’t disclose or try hard to really hide their disclosure of what their alternative measures are, then don’t trust them. This should not be hard to find and not hard to understand. Anything less than this and you have to ask why? In my experience, the harder the recon is to find, the more questionable its worth.
- If someone gained, someone else lost: Due to IFRS adjustments, a range of accounting entries can flow through a set of earnings that are not actually cash transactions. In theory, over time, cash flows and accounting should equal each other. In theory, there is no difference between theory and practice, but in practice there is. Thus, a common argument is to exclude a certain accounting entry from management’s alternative earnings as it is “non-cash flow” in nature. In this moment, though, it is important to ask if someone has directly gained from this item (if not in the same financial year then in a future one)? If someone has gained from this entry, then someone else has lost and, thus, this is quite real. For example, if a company impairs a subsidiary’s goodwill or the book value of a factory, I cannot see anyone who directly gains from this non-cash flow impairment (now or in the future). Thus, I would be comfortable with excluding this from operational earnings. But an often-excluded item from alternative earnings is management’s share-based compensation (SBC). But management directly gains from increased compensation (in some cases, across several financial years, but that does not affect this argument). Since management has gained, the company has paid, and this cost cannot be excluded from earnings.
- If it is recurring, it is part of business: Sticking with share-based compensation (SBC), if an expense is recurring, then it is part of running a business and should not be excluded from earnings. I cannot see a business running without management and, thus, expenses relating to management are recurring and should be included in the earnings of that business. An example of one-off expenses would be, for example, the one-off tax hit that Coronation has just suffered. If an expense is regularly required to operate a business, it is part of the business.
- Cash is King: However much a cliché, almost all IFRS distortions exclude the cash flow statement of a company (with the exception of IFRS 16, & SBC/buy-backs). How similar does the cash flow look to the adjusted earnings? If they are (regularly) way out without explanation, this is a red-flag that management’s alternative earnings are more alternative than earnings. The deterioration in IFRS earnings boosts the value of using reported cash flows as a measure of performance and re-emphasizes the cliché that cash is king.
In summary, IFRS’ drift towards abstraction is increasingly rendering its earnings figures less useful for investors. Management’s solution has been to publish their respective alternative earnings measures for investors, but this Wild West of financial reporting offers lots of room for dangerous creativity. Hence, investors should evaluate these alternative earnings measures considering how they are built carefully. Or just use cash flows.
ORIGINAL ARTICLE APPEARED ON MONEYWEB.