The Endless GAAP vs. Non-GAAP Debate: Instead Focus on Cash-Flow

If you read Factset’s “Earnings Insight” this weekend (and I highly recommend you read it every weekend), you will see John Butters focused on the “GAAP vs Non-GAAP” earnings debate, which surfaces a few times of year and is usually used by the Bears to support their bearish market thesis. ( My impression is that Factset is typically market agnostic so this isn’t implying that Factset is bearish, but rather than in the eternal, never-ending battle between the stock market optimists and pessimists, the “GAAP vs Non-GAAP” debate is frequently cited by the bearish camp, and in fact, in some cases, for very good reason.

Factset compared the “GAAP vs Non-GAAP” earnings of 5 Dow components in this past week’s edition and noted the substantial earnings difference between the two.

The point I’ve tried to make many times is to pay less attention to GAAP vs Non-GAAP, and pay more attention to cash-flow and more importantly “operating cash-flow per share” (OCFPS).

Here is the spreadsheet prepared based on Factset’s table from this weekend: GAAPvNonGaap with a column added to compare operating cash-flow per share with earnings. Trinity follows all of these names fundamentally, thus everyone of these companies has been modeled for years (by me) and has a lengthy spreadsheet of all the important accounting metrics.

As readers can see for all but Pfizer (which will be discussed below), OCFPS exceeds non-GAAP (or operating earnings) which in turn exceeds GAAP earnings substantially, which is typically the case.

Why focus on cash-flow per share? Well Chicago is home to many outstanding universities, and in the early 2000’s after Enron and Worldcom, and such, I ran into the Chair of the Accounting school for one of the major universities out at one of the local hot spots on the near-north side of Chicago. I asked him the question about “earnings per share” versus “operating cash-flow per share” and why neither the companies or the Street focus on the OCFPS metric. His response ? In the late 1960’s, early 1970’s, FASB and the SEC that decided that “earnings per share” was the metric to be reported since (and I quote from the distinguished Professor), “retail investors would be unable to understand operating cash-flow per share”. (I guarantee you most retail investors don’t understand the importance of “earnings per share” or how it is derived, or its importance.)

Think about the number of CFA’s practicing today, versus in the late 1960’s, early 1970’s. You would think cash-flow would have taken on a greater importance than it does today, particularly “operating cash-flow per share.”

In the great Enron collapse of the early 2000’s the Houston-based Energy analyst that Enron had fired in the late 1990’s, early 2000’s when he put a sell on the stock, when asked why he turned negative on the company, noted that when he tracked cash-flow versus net income for the energy giant, net income was moving higher while cash-flow has turned lower. He knew the company was likely “gaming” the financial accounting, while the trend in operating cash-flow was telling a different story. This is now a comparison run for every one of the companies I follow.

You can fudge cash-flow (there is a guy by the name of Charlie Mulford that wrote several books, one being the “Financial Numbers Game”), but fudging financial accounting is far easier.

The reason that cash-flow is typically higher than net income to start with, for many companies is that depreciation and amortization are “non-cash expenses” and are added back to net income in the earlier stages of operating cash-flow calculations.

Analysis / conclusion: Here is an article written on Seeking Alpha some time ago on this topic ( that addressed the same issues that Factset did, but using Tiffany’s (which reports this week by the way) as an example. Using the 5 companies listed above, which companies would (in my opinion) have the higher quality of earnings looking at operating cash-flow versus earnings per share ?

1.) Merck or Microsoft: both companies have been relatively stable without large acquisitions or divestitures, and of the two, I would give Merck the nod, just in terms of cash-flow relative to operating and GAAP earnings. Microsoft does include stock option expenses in GAAP earnings, but the Street does report non-GAAP or operating, as expected and has been the practice since the 1990’s.

2.) United Technologies: the sale of Sikorsky and the accelerated share repurchase (ASR) in Q4 ’15 really boosted the EPS numbers, but UTX has typically run both cash-flow and free-cash-flow over 100% of net income over time. It is one of the reasons the stock has been a long-term hold in client accounts. UTX is in transition now, so how the company looks exiting the transformation and how cash-flow changes will be watched carefully.

3.) GE (industrial) – because of the sale of GE Capital the company is in great transition, but GE does disclose GE Industrial cash-flow (all non GE Capital businesses) but note the cash-flow versus the earnings per share. At 30(x) cash-flow some might think that GE is pretty expensive, but that is another question entirely.

4.) Pfizer: Pfizer has yet to file their 2015 10-K or annual report so a brokerage report was used for the balance sheet and cash-flow data for Q4 ’15, which included Hospira but not Allergan. Per the model, the reason that Pfizer’s cash-flow per share is below GAAP and operating EPS is that Q4 ’15 cash-flow from operations is supposed to be a negative $7 billion Because the 10-K is not out yet I prefer not to make too many conclusions about PFE. The company is in the midst of a large transformation. Sustainable cash-flow might be better arrived at looking at 2016 data.

Ultimately this discussion ties into valuation and whether you would want to own the stock for your portfolio. All these stocks are owned for client accounts, with the top holding being Microsoft, and then GE, and then UTX, Pfizer and Merck. In addition to quality of earnings, readers have to think about sustainable growth rates, catalysts that might stimulate change, quality of management, capital return (dividends and share repurchases), market share, regulation, trade policies, tax policies, etc. etc.

Quality of earnings isn’t everything, but it isn’t a bad place to start.

Today, most CNBC bears or those cautious on the stock market note the P.E on the SP 500 of 15(x) – 17(x) and say the SP 500 is overvalued relative to its growth rate, (and they have a good point) while almost no one says that the SP 500 is trading at 10(x) cash-flow and is pretty reasonably valued relative to historical norms.

The moral of the story is when valuing companies, particularly on a P.E ratio basis, don’t forget operating cash-flow per share. It is probably a much more telling calculation. GAAP vs non-GAAP is a good discussion and worth having: GAAP and Non-GAAP vs. cash-flow is probably a better discussion.

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