In the world of corporate reporting and understanding what really goes on inside companies they own in their portfolios, investors are well-served by the Securities and Exchange Commission’s (SEC) requirement that companies file their financials each quarter. The reporting format is standardized, making it easy for the public to compare results from one quarter to the next. More importantly, all U.S. companies are required to apply generally accepted accounting principles, or GAAP, to ensure they all are using a common language and the greatest amount of transparency in their reporting.
That’s important because GAAP measures are not required in financial reporting by many companies outside the U.S. That’s the reason why U.S. companies attract so much of the world’s capital—because investors can rely on the information reported in their financials.
When GAAP Doesn’t Tell the True Story
However, while GAAP reporting is a major plus for investors, it doesn’t always paint an accurate picture of what’s going on inside a company. The problem is GAAP reporting rules can’t account for certain activities in a way that tells the true story. The best example of that is when one company acquires another company. When that happens, the acquiring company is required to write off the purchase as an expense, which is then taken against the company’s earnings.
Turning Investments into Expenses
In reality, it’s not an expense—it’s an investment, which can actually improve earnings over time. Because there is no actual deduction against earnings, it turns out to be a phantom deduction. Post-purchase, the company may be very profitable with a ton of cash in the bank, but its earnings will take a hit, now and for some time in the future, as the phantom charge is expensed over time.
The phantom deduction is made worse when you consider that most of the company’s purchase price is comprised of its Goodwill—that is, the cost of its brand, its market position, and its customer base. With many companies, the enterprise value of their Goodwill far exceeds the value of its hard assets, such as property and equipment, and it is factored into the company’s sale price. In actuality, purchasing a company’s Goodwill is not an expense—it’s an investment that grows in value over time.
Imagine if a company were big enough to buy Coca-Cola, one of the biggest brands on the planet. Coca-Cola’s Goodwill value is almost immeasurable, but if a company could afford it, they get the world-famous brand, market dominance, and access to the secret sauce that goes into making the syrup. By buying Coke’s Goodwill, that company has made a legitimate investment that will reap substantial rewards. There’s no actual cost associated with it; therefore, it’s not an actual expense. Yet the company has to expense the fact that they have paid for the Goodwill and take a big hit on their earnings.
So, what do investors see? They see depressed earnings, particularly in the year of the purchase, because GAAP requires the expense to be front-loaded in the first or second year. But that is not what’s really happening inside the company.
A Case Study of Phantom Charges from our Own Portfolio
This scenario played itself out in real-time with one of our holdings, Strategic Education (STRA). In 2018, STRA purchased Capella Educations, which turned out to be a very positive investment. Two years later, in 2020, STRA purchased an Australian-based education company, Laureate Education. So STRA was still expensing the Capella purchase at the time they had to start expensing the purchase of Laureate. Needless to say, STRA’s earnings were decimated, falling to $0.87 from $3.00. However, when you look at STRA’s non-GAAP earnings for 2020—yes, there is such a thing—you see they actually earned $6.68 a share. That’s a difference in earnings of 42% related to these non-cash charges.
So, for investors looking at the headline earnings, without an understanding of GAAP rules, they might conclude STRA’s profitability is nearly half what it was. Worse, if they’re unable to look beyond the headlines, they won’t understand that STRA’s future profits will grow even more due to their investments into Capella and Laureate. That would make them wrong twice.
In the case of STRA or any company that makes a solid acquisition, GAAP reporting can actually blur the picture of what’s really going on inside the company. For that reason, we also want to look at the non-GAAP reporting because, in essence, the phantom charges are added back in, giving us a more accurate picture of the company’s legitimate earnings.
With Non-GAAP Reporting, it’s Investor Beware
Many companies issue non-GAAP-based financials alongside their GAAP-based financials for various reasons, such as in the case we’ve been describing here. However, investors need to beware of companies that do it for, shall we say, less than noble reasons. With non-GAAP reporting, companies can pretty much do what they want to make their financials look better than what they are. While non-GAAP reporting can, in certain circumstances, provide a more accurate picture, it can also be manipulated to cloud a bad picture. Before accepting a non-GAAP report out of hand, it’s essential for investors to understand the reasons behind its use.