Category:
reset
free cash flow
08/02/2017
Here’s why GAAP is No Good for Investors in 1 Chart
By: janet Johnston
HERE’S WHY GAAP IS NO GOOD FOR INVESTORS IN 1 CHART

It’s counterintuitive but worth some serious consideration: the very same set of standards put in place to serve investors, that is, GAAP (Generally Accepted Accounting Principles), may be doing more harm than good in some cases.
[…]

READ MORE

It’s counterintuitive but worth some serious consideration: the very same set of standards put in place to serve investors, that is, GAAP (Generally Accepted Accounting Principles), may be doing more harm than good in some cases.

How Reliable is GAAP for Investors?

Public companies are required to issue reports in compliance with GAAP. While it sounds as if this standard would allow no wiggle room, the opposite is actually true; in fact, earnings results cede fairly large degrees of discretion to management when it comes to reporting for these important areas.

In its lead article one year ago, the Financial Analysts Journal (January-February 2016) published “The Misrepresentation of Earnings.” The research was the result of a survey of 400 chief financial officers, and the findings are sobering.

Consider this: Fully 20% of earnings reports were felt by the respondents to be intentionally
distorted and by a significant amount of 10%.

In an age where “missing by a penny” causes great shock to the market, this is no small finding. Further confirming the general nature of the distortions, the survey goes onto show that about two-thirds of respondents were also in favor of higher earnings.

Does GAAP Accurately Predict Stock Returns?

Since GAAP is considered to be “the standard”, one would expect to find some degree of correlation between firms that have outstanding metrics and positive forward returns. Think again.

Consider the chart below which shows one month forward returns using prior six month GAAP earnings growth:

The above chart shows a dotted line which represents the best statistical representation (technically, the line of “best fit” or trend line characterizing the data points) of the relationship between the corporate accounts as evaluated by GAAP and stock price changes one month later.

graph

Bottom Line

Companies can, and have, misinterpreted earnings when filing quarterly reports in an effort to show more encouraging earnings growth than is actually present. While standards like GAAP are put in place to protect investors, those who are unaware of the “financial gimmickry” taking place underneath the surface may be blindsided if they take earnings reports completely at face value. Do yourself a favor and educate yourself on free cash flow because it can help you conduct a more thorough and accurate analysis of a company’s true financial health.

Category:
reset