It would be hard to find a podcast-hosting duo more fully invested in answering your financial questions than Alison Southwick and Robert Brokamp -- they even put "Answers" in their show's name! This week, they're at it again, combing through the Motley Fool Answers mailbag in search of conundrums to address for their listeners. But because three heads are better than two, for this episode, they have recruited senior analyst -- and frequent podcast guest -- Ron Gross to help out.
In this segment, they tackle an excellent question from listener Tim, who wants to understand the difference between GAAP -- generally accepted accounting principles -- and non-GAAP numbers. And more to the point, why would those non-GAAP metrics be useful in evaluating a business if they don't meet the usual standards?
To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.
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This video was recorded on June 25, 2019.
Alison Southwick: Our first question comes from Tim. "I have heard some analysts on Motley Fool podcasts discuss companies' non-GAAP numbers and often followed with a chuckle."
Ron Gross: Like this?
Southwick: Non-GAAP numbers!
Robert Brokamp: Non-GAAP earnings!
Southwick: Come on!
Southwick: Oh! "My question is why is non-GAAP useful in evaluating a business? If their numbers are not in line with GAAP, what can be learned from those statistics?" And if I remember right, GAAP is general something accounting principles?
Gross: Yes, generally accepted accounting principles.
Southwick: Accepted accounting principles.
Gross: Here we go. Ready? This is going to get a little weedy, but I'll try to make it fun.
Brokamp: Not the cannabis weeds.
Southwick: Apparently we all chuckle.
Gross: No, in the weeds. In the weeds.
Southwick: Ah ha ha ha!
Gross: So companies must follow GAAP accounting by law. I don't know if law's the right word. By regulation.
Southwick: By accounting law!
Gross: But sometimes both companies and analysts want to make adjustments and look at things a little bit differently. Often that's because a company will have a one-time charge that doesn't recur -- a nonrecurring event, a nonrecurring charge -- so the company will want to point that out to investors. And analysts will want to do a little digging of their own and start to make adjustments.
Southwick: Could that example be like a lawsuit payout?
Southwick: Or what are some other examples of a one-time charge?
Gross: Something weather related.
Southwick: Oh yeah, blaming the weather is good!
Gross: But I meant like if there's a manufacturing facility that has to close down for a few days because there was a hurricane. Or even layoffs that have never happened before. You wouldn't want to necessarily project those into the future. So we want to make adjustments. But when a company does that, they're in violation of GAAP, so they have to point out they're introducing non-GAAP numbers to the world, and they really have to make that very clear.
And it's supposed to be helpful to investors. The one caveat, I would say, is if these adjustments are being made because of what we just said -- one-time events, nonrecurring events -- let's all be very sure that we buy into the fact that they're nonrecurring. Restructuring charges are kind of a notorious thing here.
There are many companies that somehow seem to have a restructuring in some form every single year; yet they count them as nonrecurring. A good analyst, a good investor will recognize that they're playing some shenanigans, here, and let's actually count that as a recurring expense and not give the company credit for this one-time event.
So you've got to be careful, but they can be very helpful. We, as analysts, adjust income statements all the time for things that aren't really kosher from a GAAP-accounting perspective, because accounting rules can be kind of wonky and sometimes they don't reflect reality, especially with things like depreciation and amortization, which are noncash expenses. People play around with those. Make adjustments for those. So non-GAAP is actually quite helpful.
Southwick: How much of your time, as an analyst and an investor, do you spend looking at these numbers, GAAP or non-GAAP or otherwise, versus anecdotally looking into the company and thinking about their future?
Gross: I would say most of the time should be looking at the qualitative. The words. What does the company do? How does it make money? Who's the management team? Does the company have a competitive advantage? Who are the competitors? What's their market share like? All those things that really help you understand the business.
And then maybe 25% -- just making that up -- is digging into the numbers. What do the growth trends look like? Is revenue trending upwards? Are they profitable? What do their margins look like? And then we can use all that information to maybe get a gauge of whether we think the stock price is fair. Cheap or expensive at any given time. But especially for just nonanalysts or everyday investors, I think you want to spend most of the time just trying to understand the business.