Do not trust adjusted company earnings, investors warned
Investors should pay little attention to adjusted profit figures published by companies, as a large proportion of listed businesses seem to be using the method to make themselves look more profitable, according to Bank J. Safra Sarasin.
In a paper on sustainable investment and governance in particular, the bank said that adjusted earnings figures were “tricky to compare”.
“A better way to assess a company’s long-term performance is to look at the cumulative free cash flow figures reported over several years,” the paper said.
It also said that because goodwill no longer had to be amortised on company balance sheets, starting in 2004, reported net profits had been higher since then.
Analysing the 20 companies in the Swiss Market Index (SMI), the bank found that if these firms had been gradually writing down the value of goodwill, their net profits would have been 10% less than they actually been reported as being in 2013.
But while the treatment of goodwill was transparent, the way adjusted profits were reported was out of control, it said in the paper.
“Unlike the statutory profit figures, there are no set accounting rules governing the way adjusted earnings figures are reported,” it said, adding that this meant there were effectively no limits on how creative companies could be.
Examples of items that could be included or excluded in the adjusted earnings figures were extraordinary income or expenses, extraordinary amortisation of tangible assets, foreign currency gains and losses and restructuring costs, it said.
Data showed that 56% of EURO STOXX 50 companies had reported adjusted net profit in 2013 that was higher than the statutory equivalent, and for a further 20% there was no difference between the two types of reported profit.
“This suggests that companies are also using the adjusted profits to conceal operating weaknesses or the negative aspects of an aggressive acquisition policy,” it said.
These adjusted figures were then often pushed to the fore in press releases and presentations, it said.
“Investors are therefore best advised to analyse not only the income statement but also the reported cash flow,” the paper went on.
Since free cash flow could fluctuate widely from one year to the next, it made sense to assess it using cumulative figures over several years, the bank said.