Warren Buffett (Trades, Portfolio) has famously said that GAAP earnings should be an investor’s beginning point when it comes to analyze a company’s earnings power. I know most of us will agree with Buffett on this point. However, many investors shiver when thinking about Non-GAAP owners’ earnings because of either unfamiliarity with accounting or the perceived complexity in figuring out the true earnings’ power of a business just by looking at the often 100 page plus SEC filings.
Although there are a few books such as Quality of Earnings by Thornton L. O'glove and Creative Cash Flow Reporting by Charles Mulford and Eugene Comiskey, in reality, it is not very practical to go through all the things discussed in those books, especially for part-time retail investors.
In this article I will share with the readers one simplified approach in terms of converting GAAP earnings to Non-GAAP owner’s earnings. This approach does not start with the 10K or 10Q because companies are required to follow GAAP strictly in the annual or quarterly financial reports.
As you may have guessed, this approach relies somewhat on the earnings release as most companies nowadays provide additional Non-GAAP financial information as supplemental information to the quarterly and yearly financials. In the earnings release, most management team would have done the job for investors already. An investor’s job is to assess whether the GAAP – Non-GAAP reconciliation is reasonable or not and make additional adjustment whenever he or she sees appropriate.
Let’s use DaVita (DVA, Financial) as an example as I think DaVita’s management team does a fairly good job communicating the real earnings’ power of the business. In the Q4 2014 earning’s release, DaVita first discloses the GAAP earnings as follows:
On a GAAP basis, it looks like DaVita had a bad quarter. However, in the later part of the earnings release, management provides two levels of adjustment to the GAAP earnings. Level 1 is the unusual activities that had an impact on the quarter. Level 2 is the activities that distort the business’s earnings’ power on an on-going basis.
As we can see, DaVita’s owner’s earnings is much higher than what GAAP has depicted. This is important if we were to value DaVita on a P/E basis. Last year DaVita’s GAAP earning is $3.33 per share. At the current price of roughly $81, DaVita’s trading at more than 24 times GAAP earnings. However, on an adjusted EPS basis of $4.13 per share, the P/E is much lower at 19.6 times.
For some of us, this may be good enough. However, if you want to go a level deeper, then you need to normalize earnings in terms of what would the margins be if DaVita is in a normalized operating environment. This would require a careful reading of the SEC filings and a much deeper understanding of the business. For instance, if you go through HealthCare Partner’s history, you will see that its patient care cost is at a very high level currently compared to what it has been in the past. HCP’s operating margin has also been much higher in the past than it is presently. Now the harder part is obviously assess whether it can revert back to normal levels as indicated by historical levels.
I think the above exercise shouldn’t take too long for an investor. But you need to be careful with the management team. For example, the following disclosure is taken from an earnings release of another company that I won’t disclose the name. This is a classic example of adding back normal operating expenses back to a dubious proxy to earnings to make the business look better than it otherwise would be.
