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In the investing world, companies can use deceptive practices that make them appear as shined-up versions of what they really are in the hopes that you will buy the “lemons” that are their shares.
It’s important to know these tricks ahead of the upcoming earnings season, as professional traders classify it as the 40 most important days of the investing year.
If you know how to more easily avoid these “lemons,” you’ll have more time to focus on the real profit opportunities.
Here are two of the most frequently used tricks that you should watch out for.
EPS Trick No. 1: Adjusting Your Way to ProfitsPublic companies, especially those with no real EPS (earnings per share), have a love affair right now with something called adjusted earnings.
Take those figures with a big box of Morton’s salt.
There are plenty of young, fast-growing companies today (mostly technology related) that are not yet profitable according to generally accepted accounting principles (GAAP).
GAAP isn’t perfect, but it’s the standard that most big, established companies use to present their financials. Other companies, not so much.
Some of these companies figured out that if they make enough adjustments to GAAP EPS, they can appear profitable on paper.
This embellished figure is labeled “adjusted earnings.” Sometimes called non-GAAP earnings or adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization), it’s an epidemic on Wall Street today.
Warren Buffett’s right-hand man Charlie Munger is a vocal critic of the accounting method, saying, “Think of the basic intellectual dishonesty that comes when you start talking about adjusted EBITDA. You’re almost announcing you’re a flake.”
To create the appearance of profitability, companies take what is supposed to be bottom-line net income (or losses) and then add back non-cash expenses like depreciation and amortization to their earnings. And just like that, they come up with much better adjusted earnings.
This is widely done with intangible assets and things like software and equipment. GAAP clearly says you should write off the value of these items over time.
But if instead you simply add them to your earnings, you can adjust your way to profits.
EPS Trick No. 2: Stock-Based CompensationAnother popular trick is a line item called “stock-based compensation.”
This is when companies (often tech companies) decide to add back the cost of stock grants and stock options that they use for employee compensation. And stock-based compensation can easily run into the hundreds of millions or even billions of dollars.
If you hire workers and pay them a salary or an hourly wage, let’s say at Ford Motor Co. (F), then you report that amount as an expense that reduces profits.
But if you hire workers at, say, Roku Inc. (ROKU) and pay them in stock or options, it’s not an expense that reduces profits. It’s just adjusted earnings.
In Q4 2019, the streaming company Roku reported a net loss of $15.7 million. But subtract $6.5 million in depreciation and amortization (trick No. 1) and $26 million in stock-based compensation costs (trick No. 2), and perform a little more financial wizardry, and presto, Roku recorded adjusted earnings of $15.1 million.
In my book, the cleanest and best measure of the true profit-earning power of a business is cash flow.
Cash flow is superior to EPS because it measures the actual movement of money into or out of a business. It’s everything the company earns from selling stuff, minus the cost of the stuff and all operating expenses it takes to produce and sell the stuff. This includes compensation of any kind.
And you can go one better with an even more conservative measure: free cash flow (FCF). This is simply operating cash flow minus capital expenditures (capex), the money used to buy and maintain physical assets such as property and equipment.
Both these figures are easy to find on a company’s quarterly financial statements.
Bottom line: Beware adjusted earnings and focus on a company’s real bottom line.