What the two have in common
In 1985, Sports Illustrated (SI) published an article titled “The Curious Case of Sidd Finch.” The article told the unbelievable story of a 28-year-old up and coming New York Mets prospect. The young pitcher’s name was Hayden “Sidd” Finch. The orphan, Harvard dropout, devout Buddhist, French horn enthusiast sported a 168-mph fastball. That’s no typo – Sidd’s fastball clocked in at one-hundred and sixty-eight miles per hour. Mets fans were ecstatic – the Messiah had finally come to bring World Series titles.
The Mets went to great lengths to keep their newfound star out of the media. During Spring training, they even built an enclosure around the bullpen to prevent spectators from laying eyes on Sidd Finch. It’s unclear whether they wanted to prevent people from witnessing the record-breaking fastball or to hide the manner in how he threw it – with a work boot on his right foot and barefoot on his left.
Investigative readers of SI may have noticed the issue date of the article – April 1, 1985. You may recognize it as April Fool’s Day! Sidd Finch was a myth, fictional, a made-up story (albeit SI did a fantastic job selling it). It was a heartbreaking realization for Mets fans. The article created quite a buzz in Major League Baseball and readers bought it hook, line, and sinker. Sidd Finch captured the hearts and minds of the sports world if only for a moment.
So, what do adjusted earnings and Sidd Finch have in common? Two things come to mind…
- Both are too good to be true
- Neither exist no matter how much we wish they did
Beware of adjusted earnings
Investors should be weary when they hear the term adjusted EBITDA, adjusted earnings, or non-GAAP earnings. Used in this context, “adjusted” and “manipulated” share the same meaning. In reporting adjusted earnings, companies are disregarding real costs to the business as if they don’t exist – examples include depreciation and, the most egregious, stock-based compensation. In doing this, companies turn themselves from a huge loss-making company to one of great profitability.
The practice seems equivalent to failing an exam, handing it back to the professor claiming a passing score was the true result, and the professor agreeing after disregarding questions answered incorrectly. This is illogical, yet it’s Wall Street’s modus operandi.
Companies that report adjusted earnings and inflate their financial results are aided and abetted by Wall Street analysts who rely on these figures to forecast future earnings. This impacts valuation ratios and price target estimates which, like Sidd Finch, are based on fiction.
Sage advice from two investing legends
Two of the greatest investors of all time agree with this notion.
“I don’t like when investment bankers talk about EBITDA, which I call bulls— earnings.” …Charlie Munger
“…it has become common for managers to tell their owners to ignore certain expense items that are all too real. ‘Stock-based compensation’ is the most egregious example. The very name says it all: ‘compensation.’ If compensation is not an expense, what is it? And, if real and recurring expenses do not belong in the calculation of earnings, where in the world do they belong?”…Warren Buffett
Consider the business fundamentals
It’s important to note the difference between a profitable company and one producing positive cashflow. Many loss-making companies that report adjusted or non-GAAP earnings have positive cashflow. Indeed, some may be great businesses with sound fundamentals, but they are not profitable. A few examples include Twitter (TWTR), Snowflake (SNOW), Crowdstrike (CWRD), and Snap (SNAP).
Here are a few questions to consider before investing in such a company:
- Is positive cashflow produced at the expense or benefit of the shareholder? Consider the dilutive effect of excess stock-based compensation.
- If stock-based compensation is subtracted from cashflow from operations, is cashflow still positive?
- Is total number of shares outstanding increasing consistently? Do not be fooled by a share repurchase program that serves only to “net out” stock-based compensation and maintain total number of shares outstanding.
There are instances where it may make sense to add back certain non-recurring expenses such as one-time inventory write-offs or amortization but adding back numerous business expenses carte blanche is manipulative and misleading. Be sure to do your homework before diving into a loss-making company that turns itself profitable with a re-shuffling of its financial statement.
