With earnings season in full swing, it's important for valuation-conscious investors to look past the headlines and examine the underlying numbers. Frequently, companies report non-GAAP results that are used to determine whether earnings have met expectations. While it's critical to understand these figures, don't make the mistake of excluding some of the items when you're assessing the valuation of a stock.
One such item to be aware of is excluded charges such as restructuring, especially when these "one-time" charges are actually recurring every year. Take a look at EMC (NYSE: EMC). Every year for the past decade, the company has recorded some type of restructuring charge. So why should I exclude those charges from regular expenses, especially since much of the money involved comes from payments related to workforce reductions? That's real cash going out the door -- year in and year out!
But restructuring is not the only culprit. Take Johnson & Johnson (NYSE: JNJ), for example, which recently reported non-GAAP earnings of $1.35. But these results excluded $0.10 a share for litigation charges and a product recall, expenses that absolutely are relevant to investors as they are uses of cash. The company also raised its guidance, but that too was worth a closer look.
Another fun trick is to adjust for what income would have been if we didn't have to expense anything. Rosetta Stone (NYSE: RST) reports a non-GAAP operating EBITDA that excludes everything you would expect from EBITDA -- interest, taxes, depreciation, and amortization -- but also adjusts for the change in deferred revenue. I have two issues with this. First, EBITDA is typically more relevant in capital-intensive businesses (think telcos, not a language product company) where expenditures from several years back are having an impact on earnings now and may not paint the proper picture to an investor. But by also including the change in deferred revenue, Rosetta Stone is suggesting that it believes revenue is earned at the start of the contract rather than over the life of the contract. That's just not consistent with how companies record revenue, and I'm not sure why the figure is relevant.
I have no issue with disclosing one-off transactions and their impact to the bottom line in a given quarter. Just don't exclude them from EPS. To say issuing checks to hundreds of terminated employees or waging a court battle isn't relevant to the company's performance is ridiculous. A P/E ratio looks a lot better when millions of dollars are excluded from expense.
