warren buffett

Acceptable Use of Adjusted Financial Metrics by (Warren Buffett)

When companies report earnings, they have the option to report ‘adjusted earnings-per-share’, which generally backs out one-time expenses such as:

  • Restructuring charges
  • Severance packages
  • One-time tax liabilities

And other metrics that are perceived to impede comparability to previous fiscal years.

Including adjusted earnings in shareholder reports is completely optional.  However, the proportion of companies who include adjusted financial metrics has been rising over time.

Warren Buffett commented on this trend in Berkshire Hathaway’s 2016 Annual Report:

 Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, “adjusted earnings” that are higher than their company’s GAAP earnings. There are many ways for practitioners to perform this legerdemain. Two of their favorites are the omission of “restructuring costs” and “stock-based compensation” as expenses.

Source: Berkshire Hathaway 2016 Annual Report, page 16

Buffett later elaborates on each of these two ‘favorites’, saying about restructuring costs:

“Berkshire, I would say, has been restructuring from the first day we took over in 1965. […] We have never, however, singled out restructuring charges and told you to ignore them in estimating our normal earning power. If there were to be some truly major expenses in a single year, I would, of course, mention it in my commentary.”

Source: Berkshire Hathaway 2016 Annual Report, page 16

And later, on the exclusion of stock-based compensation in the calculation of adjusted earnings:

“If CEOs want to leave out stock-based compensation in reporting earnings, they should be required to affirm to their owners one of two propositions: why items of value used to pay employees are not a cost or why a payroll cost should be excluded when calculating earnings.”

Source: Berkshire Hathaway 2016 Annual Report, page 16

It is perfectly acceptable for a company to report adjusted earnings under one condition – shareholders read and understand the reconciliation between adjusted earnings and GAAP earnings.

Another alternative method of presenting a company’s perceived earnings power is through EBITDA, which stands for earnings before interest, tax, depreciation, and amortization.

Warren Buffett (among others) has been vocally critical of this metric in the past, since the implication is that the four excluded costs (interest, tax, depreciation, and amortization) are not true expenses.

Every dime of depreciation expense we report is a real cost. That’s true, moreover, at most other companies. When CEOs tout EBITDA as a valuation guide, wire them up for a polygraph test.

Source: Berkshire Hathaway 2014 Annual Report, page 15

Buffett’s criticism of EBITDA has been long-standing. He also commented on the use of EBITDA in his 2002 shareholder letter, and probably earlier.

“Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business.”

Source: Berkshire Hathaway 2002 Annual Report, page 21

Overall, investors should only accept the use of adjusted financial metrics if they can understand the reconciliation between the GAAP and non-GAAP metrics.

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