What are Non-GAAP Earnings?
Non-GAAP Earnings are reported by public companies along with their GAAP financial statements.
The Generally Accepted Accounting Principles (GAAP) are the standardized set of rules for reporting earnings that publicly-traded companies in the U.S. must abide by.
However, the disclosure of non-GAAP metrics has become common practice under the notion that these reconciliations portray historical results more accurately (and improve forecasts of future performance).
Non-GAAP vs. GAAP Financial Measures
Non-GAAP earnings are meant to normalize historical performance and set a more accurate reference point for forecasts to be based upon.
While GAAP attempts to establish uniformity among the financial statements of public companies, it is still an imperfect reporting standard, with instances where GAAP earnings can become distorted.
Namely, there are two types of items that can skew earnings and cause GAAP earnings to be misleading to investors.
- Non-Recurring Items: These are non-core sources of income and expenses that are not expected to continue into the foreseeable future (e.g. restructuring charges, one-time write-downs / write-offs, gains on sales).
- Non-Cash Items: These refer to items that are related to accrual accounting concepts, such as depreciation and amortization (D&A), as well as stock-based compensation, where no real cash outflow has taken place.
Since the purpose of forecasting is to project a company’s future performance – specifically the cash flow generation from its core operations – removing the impact of these sorts of items should theoretically depict a more accurate picture of past and ongoing performance.
However, note that the validity of each non-GAAP reconciliation must be analyzed because the discretionary nature of these adjustments creates room for bias and potentially inflated earnings.
What is Adjusted EBITDA?
In particular, one of the most common non-GAAP metrics is termed “Adjusted EBITDA”.
The adjusted EBITDA metric is commonly perceived as the most accurate measure of core operating performance, as it facilitates comparisons across peer companies, irrespective of varying capital structures and tax jurisdictions.
For instance, the offer values in M&A transactions are often denoted in terms of an EV/EBITDA multiple.
To calculate EBITDA, D&A is added back to EBIT, which is followed by other adjustments such as removing stock-based compensation.
But to reiterate, these discretionary adjustments can allow companies to conceal poor GAAP operating performance with non-GAAP results.
Therefore, all non-GAAP disclosures and earnings must be viewed with sufficient skepticism to avoid being misled.
Management Adjusted EBITDA in M&A (“Normalized”)
In M&A, a pitch deck or confidential information memorandum (CIM) in practically all cases will contain a management-adjusted EBITDA figure. The management teams of companies are incentivized to illustrate the financial state of their company in the best light possible to maximize their exit valuation, making it critical to remain skeptical to avoid being misled.
Thus, our recommendation is to ignore management’s figure entirely, at least during the initial stages of analysis, and to instead calculate the company’s EBITDA objectively using your own assumptions. Once complete, the independently calculated metric can be compared to management’s guidance as a quick “sanity check,” but the more important point is to avoid over-reliance on management estimates.
Starting from EBIT, any adjustments for non-recurring income or expenses are made to get a better sense of the normalized core profitability of the company. Oftentimes, management-adjusted financial metrics are used by prospective buyers in the preliminary stages of the process until the deal reaches the later stages, during which additional in-depth diligence ensues.
In the diligence phase, the buyer – either a strategic acquirer or financial buyer (i.e. a private equity firm) – delves into the financials of the target company on a far more granular level. If deemed necessary, the buyer can also hire an independent, third-party firm (typically an accounting firm) to perform a routine quality-of-earnings (QofE) analysis to validate management’s adjustments as the transaction closing date nears.
Non-GAAP Earnings Calculator
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Non-GAAP Earnings Calculation Example
Suppose a company’s GAAP earnings for fiscal year 2021 were reported as the following:
- Revenue = $100 million
- Less: Cost of Goods Sold (COGS) = ($50) million
- Gross Profit = $50 million
- Less: Operating Expenses = ($40) million
- Earnings Before Interest and Taxes (EBIT) = $10 million
- Less: Interest Expense, net = ($5) million
- Earnings Before Taxes (EBT) = $5 million
- Less: Taxes @ 21% Tax Rate = ($1) million
- Net Income = $4 million
Given those reported figures, most would perceive the company’s financial results negatively, as its margin profile appears unsustainable.
- Operating Margin = $10 million / $100 million = 10%
- Net Profit Margin = $4 million / $100 million = 4%
But let’s say that management has also provided non-GAAP metrics as part of their disclosures to support their financial statements.
- One-Time Restructuring Expense = $6 million
- (Gain) / Loss on Asset Sale = $4 million
- Stock-Based Compensation = $10 million
All three of those items can be added back by management, resulting in a non-GAAP EBIT of $30 million.
- Non-GAAP EBIT = $10 million + $6 million + $4 million + $10 million = $30 million
Further, if D&A is $10 million, the adjusted EBITDA would be $40 million.
- Depreciation and Amortization (D&A) = $10 million
- Adjusted EBITDA = $30 million + $10 million = $40 million
Per management’s non-GAAP reconciliation, the company’s non-GAAP operating margin is 30% whereas its adjusted EBITDA margin is 40% – reflecting a financial state much more favorable what its GAAP financials implied.
- Non-GAAP Operating Margin = $30 million / $100 million = 30%
- Adjusted EBITDA Margin = $40 million / $100 million = 40%