Non gaap eps

Non-GAAP EPS

Non-GAAP earnings per share (EPS) is a financial metric used by public companies to present their financial performance by excluding certain revenues, expenses, gains, or losses that are considered non-recurring, non-cash, or otherwise not reflective of core operations. While Generally Accepted Accounting Principles (GAAP) provide a standardized framework for financial statements, non-GAAP EPS offers a supplementary view, often reflecting management's perspective on the underlying profitability of the business. This metric falls under the broader category of financial reporting.

History and Origin

The concept of non-GAAP financial measures, including non-GAAP EPS, emerged as companies sought to provide investors with a clearer picture of their ongoing operations, free from the volatility of certain accounting adjustments. Over time, the prominence and variety of these measures grew significantly, leading to increased scrutiny from regulators and investors. The Securities and Exchange Commission (SEC) began issuing guidance on the use and disclosure of non-GAAP measures to ensure they did not mislead investors. For instance, the SEC staff has periodically updated its Compliance and Disclosure Interpretations (C&DIs) regarding non-GAAP financial measures, with notable updates in December 2022 emphasizing proper presentation and the avoidance of misleading adjustments.¹⁶,¹⁵ This regulatory focus aims to ensure that while companies can offer these alternative metrics, they must also prominently reconcile them to their most directly comparable GAAP measures.¹⁴,¹³

Key Takeaways

• Non-GAAP EPS adjusts standard earnings per share by excluding specific items deemed non-recurring or non-operational by management.
• Companies use non-GAAP EPS to highlight their core business profitability and underlying trends.
• The SEC requires companies to reconcile non-GAAP measures to their GAAP equivalents and explain their usefulness.
• Critics caution that non-GAAP adjustments can sometimes be used to present an overly optimistic view of net income.
• Investors should analyze non-GAAP EPS in conjunction with GAAP EPS and other financial data for a comprehensive understanding.

Formula and Calculation

The basic formula for GAAP EPS is:

Non-GAAP EPS begins with the GAAP net income and then adds back or subtracts specific items that management believes obscure the true operational performance. There is no single universal formula for non-GAAP EPS, as the adjustments vary by company and industry.
For example, a common non-GAAP EPS calculation might look like:

Where:

• Net Income is the company's profit as reported on the income statement under GAAP.
• Preferred Dividends are payments made to shareholders holding preferred stock.
• Non-GAAP Adjustments can include items like restructuring charges, amortization of acquired intangible assets, stock-based compensation, impairment charges, or significant one-time gains or losses.
• Weighted Average Common Shares Outstanding represents the average number of common shares available during the reporting period.

Interpreting the Non-GAAP EPS

Interpreting non-GAAP EPS requires careful consideration. Companies present non-GAAP EPS with the intention of providing insights into their recurring operational profitability, arguing that certain items, such as one-time legal settlements or significant restructuring costs, do not reflect the ongoing performance of the business. When evaluating a company, analysts and investors often use non-GAAP EPS as a tool to assess the sustainable financial performance of a company, particularly when comparing performance across different periods or against competitors. However, the discretion involved in determining which items to exclude necessitates a thorough review of the company's reconciliation disclosures. A common practice in investor relations is to focus on these adjusted figures during earnings calls.

Hypothetical Example

Consider a hypothetical technology company, "Tech Innovations Inc."

For the fiscal year, Tech Innovations reports the following under GAAP:

• Net Income: $100 million
• Preferred Dividends: $0
• Weighted Average Common Shares Outstanding: 50 million shares

Its GAAP EPS would be:
( \text{GAAP EPS} = \frac{$100 \text{ million}}{50 \text{ million shares}} = $2.00 \text{ per share} )

However, Tech Innovations' management believes that two items distorted its core operating performance:

1. A one-time restructuring charge of $20 million related to streamlining operations.
2. $5 million in amortization expense related to a recent acquisition's intangible assets, which is a non-cash expense.

To calculate non-GAAP EPS, management would adjust the net income:
Adjusted Net Income = $100 million (GAAP Net Income) + $20 million (Restructuring Charge) + $5 million (Amortization Expense) = $125 million

Non-GAAP EPS = ( \frac{$125 \text{ million}}{50 \text{ million shares}} = $2.50 \text{ per share} )

In this example, Tech Innovations might present a non-GAAP EPS of $2.50, alongside its GAAP EPS of $2.00, to illustrate its profitability excluding these specific items. This allows for a deeper understanding of the company's ongoing operational trends, independent of non-recurring or non-cash charges.

Practical Applications

Non-GAAP EPS is widely used in various financial contexts, particularly in corporate finance and investment analysis. Public companies frequently emphasize non-GAAP EPS in their earnings releases and investor presentations to communicate their perceived core profitability.¹²,¹¹ For example, a company might report higher non-GAAP EPS despite a dip in GAAP EPS due to one-off events, aiming to reassure the market about underlying operational strength.

Financial analysts often incorporate non-GAAP EPS into their valuation models and earnings forecasts, believing it can offer a more consistent measure of cash flow generation and ongoing business performance.¹⁰,⁹ Additionally, non-GAAP earnings metrics are sometimes tied to executive compensation, raising concerns among investor groups.⁸ The Council of Institutional Investors (CII), for instance, has urged the SEC to tighten rules around the use of non-GAAP measures in determining executive pay, citing research that suggests a correlation between higher non-GAAP earnings relative to GAAP earnings and abnormally high CEO compensation.⁷

Limitations and Criticisms

Despite its widespread use, non-GAAP EPS faces significant limitations and criticisms. The primary concern stems from the flexibility companies have in determining which items to exclude from their GAAP results. This discretion can lead to figures that may not accurately reflect a company's financial health or can be manipulated to present a more favorable picture than what GAAP would show. For instance, some companies might consistently exclude "non-recurring" charges that, in practice, recur frequently. The CFA Institute, a global association of investment professionals, has highlighted investor concerns regarding the communication, consistency, comparability, and transparency of non-GAAP financial measures.⁶,⁵

Academics have also pointed out that the increased reliance on non-GAAP metrics has coincided with a proliferation of large earnings surprises, where reported earnings exceed analyst forecasts by a significant margin. This phenomenon is partly attributed to the ability to adjust non-GAAP numbers, such as excluding transitory items that decrease earnings while including those that increase them.⁴ Investors must exercise caution, as a mispricing could occur if they fail to differentiate between a GAAP-based EPS and an adjusted non-GAAP EPS, potentially leading to an overstatement of headline profitability.³ The SEC continuously monitors these practices through Regulation G and Item 10(e) of Regulation S-K, requiring companies to avoid misleading non-GAAP presentations.²,¹

Non-GAAP EPS vs. GAAP EPS

The fundamental difference between non-GAAP EPS and GAAP EPS lies in the accounting principles used. GAAP EPS is calculated strictly according to Generally Accepted Accounting Principles, which are a common set of accounting standards and procedures established by organizations like the Financial Accounting Standards Board (FASB) in the U.S. These principles ensure consistency and comparability across companies, covering aspects like accrual accounting, revenue recognition, and expense matching.

Non-GAAP EPS, conversely, deviates from these strict guidelines by allowing companies to exclude or include specific items. While GAAP EPS provides a standard and verifiable measure of a company's profitability, non-GAAP EPS offers a customized view, often highlighting "core" or "adjusted" earnings by removing what management considers unusual, non-recurring, or non-cash items. The potential for confusion arises because non-GAAP EPS is often presented prominently by companies, sometimes leading investors to prioritize it over the GAAP figure. Understanding both metrics is crucial, as non-GAAP EPS aims to provide additional insight, but it lacks the stringent standardization and independent verification inherent in GAAP measures.

FAQs

Why do companies report non-GAAP EPS?

Companies report non-GAAP EPS to provide investors with an alternative view of their financial performance, often attempting to highlight the profitability of their ongoing core business operations by excluding items they consider non-recurring, unusual, or non-cash.

Is non-GAAP EPS more accurate than GAAP EPS?

Neither non-GAAP EPS nor GAAP EPS is inherently "more accurate." GAAP EPS is standardized and provides a consistent baseline, while non-GAAP EPS offers management's interpretation of underlying profitability. Investors should use both in conjunction for a complete picture of a company's financial health.

What kind of adjustments are typically made in non-GAAP EPS?

Common adjustments for non-GAAP EPS include the exclusion of restructuring costs, stock-based compensation, amortization of intangible assets, one-time gains or losses from asset sales, and legal settlements. The specific adjustments vary by company and industry.

Are there regulations for non-GAAP EPS?

Yes, in the U.S., the SEC regulates the use of non-GAAP financial measures through Regulation G and Item 10(e) of Regulation S-K. These regulations require companies to reconcile non-GAAP measures to their most directly comparable GAAP measures and explain why the non-GAAP measure provides useful information, while also prohibiting misleading presentations.

How should investors use non-GAAP EPS?

Investors should use non-GAAP EPS as a supplementary tool, not a replacement for GAAP EPS. It can offer insights into a company's operational trends, but it's crucial to examine the reconciliation to GAAP figures and understand the nature of the adjustments. Comparing a company's non-GAAP EPS over time and against competitors requires careful attention to consistency in the adjustments made.