In August 2015, pharmaceutical company Valeant was riding high. By late October, the company would lose nearly $60 billion in market value. Now, after greater scrutiny and criticism, Valeant's stock is down more than 85 percent from its high.
A major cause of the rise — and the fall — was so-called pro forma results. Companies can use measures other than generally accepted accounting principles, or GAAP, the gold standard for U.S. accounting, to report results so long as they also include the GAAP measures. And it turns out that many paint an increasingly unrealistic picture of their performance.
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Investors who do their homework regularly check the earnings releases of the stocks they own or find of interest. But there's a possibly dangerous trend of advertised results not being all they seem. This is a case of what you think you know being able to hurt you.
Valeant, for example, provided a pro forma view in its earnings reports that, among other things, stripped out the costs of acquiring other pharmaceutical firms for their drugs — a key part of the company’s business model. Under that constructed measure, the company looked to be doing far better than it actually was.
S&P 500 companies increased earnings 0.4 percent between 2014 and 2015, according to financial data and analysis firm FactSet as reported by The Wall Street Journal. It was the weakest performance since 2009.
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But things were actually worse. That meager gain was calculated using company-supplied pro forma numbers. GAAP results and earnings per share fell by 12.7 percent. The difference between the pro forma and GAAP results — 25 percent — was the widest since 2008. Translation: Publicly held businesses increasingly depend on pro forma results to look good.
When Pro Forma Goes Wrong
Pro forma results can offer reasonable insight into a company's performance that GAAP accounting doesn't show. A business might see a big loss under GAAP because a storm destroyed a factory. A pro forma view can show how the company did compared to usual by backing out the event.
But pro forma treatments can also cover a multitude of sins. Valeant looked at performance without amortization, which is a critical factor for intangible assets. But ignoring depreciation, which similarly calculates the loss of value over time of tangible assets, can be as problematic.
"Depreciation [is] a real expense on capital assets because they will need to be replaced," said Richard Trimber, senior counsel in the corporate practice group of the law firm General Counsel and a former COO. "It will require investment, so don’t pretend it gets dusted away on an earnings call. Telecoms are famous for this."
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Another danger is when companies provide future earnings forecasts in non-GAAP terms and use numbers that convey a precision that doesn't exist. "Many pro formas aren't cast in round numbers," said Robert Johnson, CEO of the American College of Financial Services. "When people see specificity in some of the numbers, it gives unsophisticated investors the illusion of precision. 'Earnings per share are forecast to be $5.08 a share.' People lock onto those numbers and think they are more certain."
Some companies create their own custom measures. When Groupon first planned to go public, it referred to "adjusted consolidated segment operating income," which ignored, among other things, the enormous marketing budget that fueled its growth. Under this measure, in the first quarter of 2011, Groupon claimed income of $82 million, even though it had a GAAP net loss of $114 million.
Pro forma-type statements are common and widely used. Kristian Allee, assistant professor of accounting at the University of Wisconsin-Madison, and some fellow researchers found that in 30,000 corporate earnings conference calls, over half had at least one phrase associated with pro forma results. The average number of pro forma phrase references was 3.24 per call.
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Not only are pro forma measures often used, but the impact is heaviest on those who aren't professional investors.
"It appears that the inclusion of pro forma numbers adversely affects less sophisticated investors more than more sophisticated investors," Allee said.
He and his colleagues analyzed trading patterns, using the size of trades as an indicator of the sophistication of the investor. For the time period they studied, larger trades correlated with more sophisticated investors. Smaller trades were much more likely to be made by smaller investors. "The smart money wasn't trading on the pro forma number but rather seemed to be trading on fundamentals," he said. "The smaller trades seemed to be following the information in the pro forma earnings versus the GAAP earnings."
The implication is that individual investors were ready to pay a premium that stocks might not deserve.
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To know when pro forma numbers are reasonable and not a potential marketing tool to improve the perception of a company’s results, investors should ask some questions that Deloitte & Touche suggests for companies considering the use of pro forma statements:
- Does the pro forma treatment receive the same treatment as GAAP or is it given emphasis?
- Is the measure clearly labeled as non-GAAP and defined?
- Is there a clear explanation of how GAAP results have been adjusted to create the pro forma?
- Does management explain why it uses the measurement and what the value to investors is?
- Is the same measure used in every reporting period and do other companies in the same industry use it?
- Does the measure account for non-recurring revenues or gains as well as expenses or losses?
- Are the adjustments to material issues, not immaterial ones?
You could also add to the list whether the pro forma figures omit what should be a regular cost for a business of this type or if the company created a new type of measurement to state its results.
If the answer to any of these questions is yes, what the company is doing may still be legitimate. But it's a good reason to be particularly careful and to read all the information, including the GAAP results, closely.
