As an individual investor managing your own stocks, you undoubtedly follow earnings closely, since these reported figures can greatly affect the price of a stock. Unfortunately, earnings are never straightforward and can be calculated several ways. In fact, depending on where you look for earnings data, there can be vastly different figures given for the same company. This is due to the fact that firms and analysts can treat the items used to calculate earnings differently.
You may have noticed that firms will often report several variations on their earnings figure. A standard set of accounting rules and procedures, known as GAAP (generally accepted accounting principles), applies when reporting earnings figures and compiling financial statements. U.S. companies must abide by GAAP, making it difficult for firms to report faulty figures and ensuring that earnings figures are comparable among all publicly traded firms.
However, GAAP earnings figures do not always accurately represent the earnings for a firm. To make earnings more comparable from period to period and with other firms, analysts often “adjust” their earnings, leaving abnormal and nonrecurring income and expenses out. The goal is an earnings figure that is a more accurate representation of the firm’s true core business earnings potential.
In this Fundamental Focus, different types of earnings per share figures are explored. In addition, a detailed example shows how different earnings adjustments can radically affect reported earnings.
GAAP earnings prepared by a company meet the generally accepted accounting principles. This earnings per share figure is the number used by companies when filing their SEC statements, which are all audited by outside auditors. Companies will always report earnings in accordance with GAAP, but some may also report adjusted figures.
There are several different GAAP earnings that companies may report. You need to make sure you know which earnings figure is being reported to stay consistent when comparing earnings figures. The three most common GAAP earnings are:
- basic earnings per share,
- earnings from continuing operations and
- diluted earnings from continuing operations.
Basic earnings per share is simply a firm’s net income less any preferred dividends divided by the average number of shares outstanding. It measures the amount of earnings a firm generates for each share of outstanding common stock.
Earnings from continuing operations describes earnings from a company’s “core” business operations that it is expected to operate for the foreseeable future.
For example, a technology firm that accrued a gain on the sale of assets would not include that gain when calculating earnings from continuing operations, as the sale was a one-time event that will not be recurring period after period.
Management has some leeway in deciding what income and expenses to exclude when preparing earnings from continuing operations. However, the figure has to be prepared according to GAAP and is highly scrutinized by auditors.
Diluted earnings from continuing operations is also reported by companies if potentially dilutive securities are a part of its capital structure. Dilutive securities are financial instruments that, if exercised, increase the number of outstanding common stock. These include stock options and warrants, convertible bonds and convertible preferred stock. Diluted earnings from continuing operations calculates a company’s earnings per share using a fully diluted shares outstanding number, which includes the impact of all outstanding dilutive securities. In essence, it represents the “worse-case scenario,” since the exercise of all dilutive securities would reduce earnings per share.
Adjusted earnings, or “pro-forma” earnings, is a non-GAAP figure calculated by company management or analysts. It is used in an attempt to present a figure that is a better representation of a firm’s profitability and business outlook. Whether this adjusted figure actually accomplishes that task is up for debate.
Items that are commonly left out of adjusted figures include restructuring and merger costs, losses at affiliates, goodwill write-downs and other one-time expenses. In addition, management may also even leave out depreciation, amortization and stock-based employee compensation.
When a company releases adjusted earnings, make sure to note the key differences between the adjusted figure and the reported GAAP earnings figure. Adjusted figures are not subject to the same level of regulation as figures reported in accordance to GAAP. However, management is required to present the differences in GAAP and adjusted earnings figures. It is up to the investor to make sure adjustments were sensibly made.
A Closer Look
Looking at Microsoft Corp.’s (MSFT) last earnings release can help illustrate the differences in earnings figures. Figure 1 shows Microsoft’s fourth-quarter 2013 earnings announcement, released on July 18, 2013, giving two diluted earnings figures: one in accordance with GAAP and one adjusted figure that does not follow GAAP. GAAP diluted earnings were reported at $0.59 per share.
During Microsoft’s fourth quarter, there was an income and an expense that deserve further scrutiny. During the quarter, Microsoft was having trouble selling the Surface RT tablets and lowered the price of the tablet from $500 to $350. Accordingly, the company wrote down their inventory by $900 million and charged the expense to the quarter as required by GAAP rules. The fourth-quarter financial results also include the recognition of $782 million of previously deferred revenue related to Microsoft’s Windows Update offer. This Windows Update offer allowed buyers of Windows 7 (after Windows 8 was announced) to upgrade to Windows 8 for $14.99. Following GAAP rules, the revenue from this upgrade offer was recorded as revenue for the fourth quarter of 2013.
This income and expense are both, arguably, one-time nonrecurring items that can be reasonably adjusted. Microsoft took the conservative route and adjusted their earnings downward, taking out the revenue from the Windows Update offer but leaving in the expense from the Surface write-down. The company incurred a $0.07 per share expense for the write-down and reported adjusted earnings for the quarter of $0.52 per share, compared to GAAP earnings of $0.59 per share.
Websites such as Reuters and brokerages such as Scottrade chose to adjust Microsoft’s earnings in the completely opposite manner, adding back the $0.07 per share expense incurred by Microsoft for the Surface write-down and leaving in the extra income earned through the Windows Update Offer. Therefore, Reuters and Scottrade both report earnings of $0.66 per share for Microsoft in the fourth-quarter of 2013, as shown in Figure 2. Stock Investor Pro, AAII’s stock screening and research database, also lists $0.66 per share.
It is imperative to understand how any earnings figures are derived. Companies that present an adjusted figure are required to show how it differs from earnings reported in accordance with GAAP. But it is ultimately your responsibility as an individual investor to decide whether the adjustments make sense.