When the Unicorn Eats Your Earnings

They are the unicorns of the corporate accounting world—those “once-in-a-lifetime” charges that creep into quarterly results with remarkable regularity. In financial releases, they are tagged as adjustments and ignored in calculations of non-GAAP earnings.

Originally utilized sparingly as a way to explain unique events, businesses, as shown, have become more aggressive in using the trick to turn lackluster results into income growth. Of course not every company relies on adjustments but we have noticed an uptick in those excluding items ranging from pension costs to stock options when reporting results. For example, Netflix, Inc. (NFLX) backs out stock-based compensation in its adjusted earnings, even though the cost is more than 20% of general expenses and is the third largest expenditure behind only marketing and content purchases. This expense is real and could result in shareholder dilution in the years ahead, yet the only way to find it is to dig through SEC filings.

For active investors, the solution is straight forward—comb through profit and loss statements, evaluate accounting changes to determine if they are extraordinary events, and develop a realistic view of results to determine a business’ intrinsic value.

Passive investors don’t have that luxury. They can’t avoid companies that have come to rely on these “rare” adjustments. Instead, they are forced to buy and sell an index based purely on companies’ market value—regardless of valuation or accounting practices. When investors eventually turn their attention back to the quality of profits, passive investors may wish they’d been more selective.