This feature looks at the increasing trend for companies to present adjusted financial figures and/or APM (alternative performance measures) and asks whether it may say something about the companies themselves.

For example, do companies which provide unadjusted numbers make better long-term investments?

Fund manager David Beggs at Sanford DeLand believes that may be the case, telling Shares: ‘Companies which report clean, unadjusted financials are increasingly rare in today’s market – but they often prove to be among the most successful long-term investments.’

‘Clean financials can be an indicator of a strong business franchise that is able to deliver high-quality earnings consistently without the need for “smoothing” by the CFO in the form of “adjustments” each year,’ explains Beggs.

Sanford Deland examples of clean accounts

THE ‘RAW’ AND THE ‘COOKED’

Companies are required to prepare annual accounts under the Companies Act 2006, but they can choose which accounting standards to use.

In the UK and Europe, companies report under the IFRS (International Financial Reporting Standards) standards while in the US firms use GAAP (Generally Accepted Accounting Principles) measures.

It may seem reasonable for companies to offer a nuanced view of performance (accountants are far from perfect), but the issue is analysts tend to base forecasts on adjusted numbers which means statutory results tend to get less scrutiny.

A knock-on effect is incentives and executive pay are often based on APM which consequently can change company behaviours.

We are not suggesting all companies which adjust numbers are bad, simply that cleaner accounts reflect good corporate governance and a refreshing honesty with shareholders.

As Beggs says: ‘The raw numbers can speak for themselves. They suggest strong internal controls, accounting discipline and a conservative management culture.’

This table aims to provide a list of companies which appear to adopt clean accounts, but it’s also worth discussing some commonly used alternative performance measures.

EBITDA IS NOT CASH

The late Charlie Munger had an almost pathological candour about him. ‘I think you would understand any presentation using the word EBITDA if every time you saw that word, you just substituted the phrase with bull**** earnings,’ fumed Munger.

EBITDA (earnings before interest, tax, depreciation, and amortisation) was popularised by private equity firms as a proxy for cash flow, allowing them to maximise the amount of leverage they could use.

However, it has a major drawback, because depreciation is a real business cost.

Most firms own assets, and most assets depreciate with use, so depreciation is a real cost to a business, and assumptions about the useful life of an asset have consequences for reported profits.

For example, if company A assumes five years of useful life and company B believes seven years is about right, company A will, all else being equal, report lower profitability, even though it is adopting a potentially more prudent approach.

In any case, why use a proxy for cash when all companies report the real thing? Simply head to the cash flow statement and look for ‘cash generated from operations’ to get a more useful picture.

Operating cash flow minus normalised capital expenditures (maintenance spending) is often the best measure of sustainable cash flow, although few companies divulge their maintenance capital expenditure.

Some companies calculate adjusted EBITDA which usually involves removing one-off, non-recuring or irregular items. The culprits are typically costs related to acquisitions or asset write-downs.

This covers a wider category of adjustments related to non-recurring items, and in some cases they can provide a clearer picture of underlying operations.

That is not the case with companies which regularly make acquisitions as part of their growth strategy. If the same non-recurring items appear every year, they are clearly part of everyday business operations and should be treated as such.

Another potential banana skin for watch out for is when a company is undergoing a multi-year period of restructuring and regularly excludes the associated costs.

Sometimes companies get even more creative. Beggs highlights the example of shared office space company WeWork which was once valued at $47 billion.

‘WeWork coined the term ‘Community Adjusted EBITDA’ when marketing its debut bond offering in 2018, an eyebrow-raising attempt to strip out nearly all operating expenses,’ says Beggs.

It is also worth flagging the significant $300 million of stock-based compensation which was effectively ignored, despite stock compensation being a real cost.

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