Don't Get Scammed by Financial Engineering This Earnings Season

Wall Street is playing a game with your money.

And just about everyone on the Street is in on it... Analysts, financial media, data compilers, CEOs are all working in concert to obscure the information you need to make the most fundamentally important investment decision of all: to buy or to sell.

The game is "hide the earnings," and, naturally, its sole purpose is to make corporate earnings look better (often a lot better) than they actually are. After all, central banks, macro events, and existential crises all impact share prices, but it's earnings that really drive them.

If it all sounds like a con, well... it is. A perfectly legal one, pulled off with "creative accounting" that puts dubious non-GAAP earnings ahead of consistent, reliable generally accepted accounting principles-derived earnings.

So today, I'm going to name names and tell you about one of the biggest culprits this earnings season.

And, since it's very likely you own these shares, I'm going to show you a really simple calculation you can use to get to the truth, because you certainly can't expect it from Wall Street.

The Wide Gap Between GAAP and Non-GAAP

Last year is just another example of the disparity between real and unreal earnings numbers.  According to The Wall Street Journal, headline or pro-forma earnings for companies in the S&P 500 in 2015 were 25% higher than GAAP earnings. That's the biggest disparity since 2008. A CNBC analysis found a similar gap in 2015 earnings.

In February 2016, regarding 2015 earnings, FactSet (which is practically the only data compiler worth listening to) reported that:

...67 percent of the companies in the Dow Jones Industrial Average reported non-GAAP earnings per share and, on average, that the difference between the GAAP and non-GAAP earnings per share for these companies was approximately 30 percent, representing a significant increase from approximately 12 percent in 2014.

If you just follow the yellow brick road, paved for us by the likes of Bank of America Merrill Lynch, you're probably feeling positive about the earnings reports coming at us like a fire hose this quarter.

A Bank of America report last week said,

With the conclusion of Week 2, 133 companies representing 40% of S&P 500 earnings have reported. Overall for the S&P 500, 67% of companies have beaten on EPS, 57% have beaten on sales, and 44% have beaten on both-an improvement from the prior week, and much better than we saw this time last quarter, when just one-fourth of companies beat on both EPS and sales.

Of course there are a lot of "beats" this quarter. Analysts have been furiously ratcheting down their earnings estimates since January, while company accountants, with executives standing tall over them, have been making "adjustments" right and left in their earnings and expense columns.

And our often asleep at the wheel regulators are starting to raise concerns that all this gimmickry is going to eventually cause trouble in the markets...

It's So Bad, Even Regulators Are Starting to Notice

The SEC is worried about how investors are being misled.

Last month, U.S. Securities and Exchange Commission Chair Mary Jo White, addressing a U.S. Chamber of Commerce audience, told guests, "We have a lot of concern about the use of these measures and whether they may be confusing to investors and analysts."

She shouldn't worry they're confusing to analysts - that's bunk. Analysts know the game.

And SEC chief accountant James Schnurr criticized the rampant use of non-GAAP measures in a recent speech, saying, "SEC staff has observed a significant and, in some respects, troubling increase ... in the use of, and nature of adjustments within, non-GAAP measures."  Schnurr additionally stated that non-GAAP measures should "supplement ... not supplant" the information in the financial statements.

Even Warren Buffett's been chiding non-GAAP earnings, noting the difference between GAAP and non-GAAP results is challenging for the average investor to interpret, and that they can't count on analysts to clear it up because executives and some analysts are "guilty of propagating misleading numbers that can deceive investors."

Here's how bad it is now...

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Case Study: GAAP Earnings vs. Non-GAAP Earnings

I want to illustrate the distinct difference between GAAP numbers and Non-GAAP numbers with two recent, real world examples.

You may have noticed that Apple Inc.'s (Nasdaq: AAPL) earnings grossly disappointed this week - the company posted its first quarter-to-quarter revenue decline since 2003 - and the stock got beaten down.
apple-stock-pic

The company released earnings after the bell on Wednesday, when the stock closed at $104.30. On Thursday, the stock opened 8% lower.

It's disappointing, even troubling - since the company didn't forecast any growth, and in fact lowered their guidance for Q3 - but Apple doesn't report non-GAAP earnings, they only report earnings derived from generally accepted accounting principles.

While the truth hurt them, at least their investors know how the company's really doing and can make investment decisions accordingly.

But Facebook Inc. (Nasdaq: FB)? Eh, not so much...

Zuckerberg & Co. trumpeted their non-GAAP earnings on Wednesday after the close, and the stock took off like a rocket.facebook-stock-pic

While the immediate focus was on the $5.382 billion in revenue Facebook posted for the quarter versus last year's revenue of $3.543, under the hood, non-GAAP numbers rolled out to the public masked less robust GAAP metrics.

Facebook pointed to income from operations being $2.977 billion, but GAAP income was $2.009 billion. Operating margins looked great at 55%, but the GAAP margin was 37%. And non-GAAP net income at $2.229 billion and diluted earnings per share of $0.77 looked a lot better than GAAP net income of $1.510 billion and GAAP EPS of $0.52.

That's what good non-GAAP numbers can do, especially in a tough market looking for companies that clobber consensus estimates.

Still, Facebook is making huge strides no matter how they tell the tale of their earnings, so perhaps the stock would have gone up anyway.

But would it have gone up as much as it did? Maybe not.

How to Protect Your Investments from This Game

So with all these different numbers, different accounting practices, and different reporting methods, what's an investor to do?

My advice: When a company announces earnings, pay close attention. Read the reports, listen to the conference calls, and pay as much attention to the numbers they aren't talking about.

Here's a quick checklist that you can use to help you assess viability of non-GAAP earnings numbers:

  • Always compare non-GAAP and GAAP numbers side by side.
  • Make sure company executives adequately explain the reasons for the adjustments represented by non-GAAP numbers. If they don't, I don't trust them.
  • If non-GAAP numbers are the norm for the company, check explanations and footnotes to see if they are consistently calculated and when and why and how they're applied from quarter to quarter.
  • Non-GAAP numbers work both ways - accounting for both nonrecurring expenses as well as nonrecurring gains, if some non-recurring gain magically fills what would otherwise be a bad number, apply the bad smell test to that entry.

Additionally, I always look at all numbers sequentially.

For example, I look at changes in top-line revenue sequentially over the past four quarters to a year ago, because how a company is doing in sales and generating revenue is hard to mess with.

If you look at all the components that make up earnings numbers through the sequential prism, it's a lot easier to pick up anomalies anywhere they might otherwise be missed if that quarter's numbers are just compared to the year ago quarter.

At the end of this earnings season, I'll follow up with a complete breakdown of the highs and lows, the good, the bad, and the ugly stories that will give you the whole picture of 2016's first-quarter earnings and how to value the market.

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About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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