Here’s our Mailbag email investingclubmailbag@cnbc.com — so you send your questions directly to Jim Cramer and his team of analysts. Remember, we can’t offer personal investing advice. Well only consider more general questions about the investment process or stocks in the portfolio or related industries. This week’s question: When reporting non-GAAP earnings, how do companies determine the numbers that are not generally accepted and how reliable they are? — Don Generally accepted accounting principles, or GAAP for short, refer to the set of accounting and reporting standards issued by the Financial Accounting Standards Board (FASB). All U.S. public companies must use GAAP when filing their financial statements. The methodology was designed to make financial data more reliable and easier to compare across companies, industries and sectors. However, many management teams argue that this single set of rules doesn’t effectively capture the health of their businesses, and so provide “adjusted,” or non-GAAP, data. Industry-specific metrics such as same-store sales, billings, and average revenue per user (ARPU) are examples of useful non-GAAP metrics. A company may be working on longer-term contracts that are not fully realized in a single reporting period or is working to grow recurring revenue streams management wants to separate from overall revenue in order to improve transparency. There are also many non-GAAP metrics that companies in all industries tend to use. You might be surprised to learn that commonly used metrics such as EBITDA (earnings before interest, taxes, depreciation and amortization) and free cash flow are not GAAP metrics, despite their popularity. These adjusted numbers are reliable. Inaccurate reporting would be fraud. The question is more whether the data is useful as the basis of an investment. One thing that separates fledgling investors from the pros is reading financial statements. Here’s our five-part series to help Club members better understand all the tables and charts and how to analyze them. Here’s an example to consider. Many companies pay employees in equity (stock-based compensation), a non-cash expense that helps boost operating cash flows since no cash charge is realized. It also increases free cash flow, which is operating cash flow less capital expenditures. On the income statement, the stock-based compensation is recorded as an expense that is reflected in GAAP earnings. But many companies add back what was expensed for non-GAAP earnings. While we tend to accept the practice given how common it is — and more importantly because analysts and investors often look to the non-GAAP numbers when valuing a company — not all investors accept the practice. That’s because shareholders still pay for stock-based compensation in one of two ways, even it not recorded as a cash charge. The company issues shares to employees and doesn’t do a buyback, in which case existing shareholders get diluted (more shares outstanding, reflected on the balance sheet). The company issues shares to employees and does do a buyback, an arguably more deceptive practice. In this case, the employee is paid in stock and operating cash flow (and therefore free cash flow) increases due to the lack of an operating cash reduction. However, the company then buys back stock in the open market, an action that gets recorded on the cash flow statement as a financing activity. Some may take issue with this, arguing that it masks the true cash charge being paid out to employees. After all, if a company pays employees $100 million in stock (noncash but dilutive) and then buys back $100 million worth of shares (with cash, to offset the dilution of stock-based compensation) in the open market, has it not paid out $100 million cash to cover salaries? Restructuring charges are another item often added back to determine adjusted non-GAAP earnings results. This is less controversial since restructuring charges are often a one-time item and don’t dilute existing shareholders. Bottom line We love to see companies refraining from breaking out non-GAAP numbers. Most mega-caps, including our Club names Meta Platforms (META), Microsoft (MSFT), Amazon (AMZN), Alphabet (GOOGL) and Apple (AAPL) typically report this way. We like it because it means that every expense — be it one-time, stock-based or the result of amortization/deprecation — is being reflected in the earnings number and that the GAAP number is most likely what will be used as the basis for valuation. 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Here’s our Mailbag email investingclubmailbag@cnbc.com — so you send your questions directly to Jim Cramer and his team of analysts. Remember, we can’t offer personal investing advice. Well only consider more general questions about the investment process or stocks in the portfolio or related industries.
This week’s question: When reporting non-GAAP earnings, how do companies determine the numbers that are not generally accepted and how reliable they are? — Don