Ah, earnings season. The two times each year when company investor relations staff really earn their money. Maybe you've heard the joke about accountants:
A businessman was interviewing job applicants for the position of manager of a large division. An accountant applied for the role. When he asked him what two plus two was, the accountant got up from his chair, went over to the door, closed it, came back and sat down. Leaning across the desk, he said in a low voice, "How much do you want it to be?" He got the job.
Like many jokes, it's funny because it's, well, if not true, at least plausible.
And if accountants have a bit of latitude when it comes to preparing financial statements, you just know the investor relations team is at least tempted to put the best spin on things.
Choose your own adventure
It's tempting to choose the best profit figure to report. And there are plenty to choose from. Working backwards from the bottom line, there is NPAT (net profit after tax), NPBT (net profit before tax) EBITDA (earnings before interest, tax, depreciation and amortisation) and EBIT (earnings before interest and tax). Because each of those can be impacted differently by various factors, it's very possible to have strong EBIT growth (for example) and still see NPAT crash. Or the exact opposite can be true.
If that's not enough, there are 'management' numbers, 'underlying' numbers and numbers for 'continuing operations' (that is, after allowing for the sale of one or more divisions of the company).
Now, if you're a company accountant or investor relations executive reading this, don't start burning me in effigy just yet. Even if many do the right thing, there are some in their respective fields who are giving them a bad name, just as bad financial planners give the good guys a bad rap.
And we're far from cynical here at the Motley Fool. If we thought companies on the ASX were irredeemable, we'd be doing something else for a job — and investing our money elsewhere. The majority of companies and their financial and IR experts are doing the right thing.
It's natural to want to present your company's financials in the best possible light. Even some shareholders (mistakenly) want their managers to do just that. The best management teams resist the urge — and so they should.
So what can individual investors do to recognise corporate 'spin', and how can we cut through it?
Acknowledge that it happens
Be aware that some companies deliberately try to spin their results, and hard. Be aware that some companies don't mean to spin, per se, but in their efforts to show how well they've done, they can end up being selective in their communications. Forewarned is forearmed, Fool!
Compare the numbers
Does the company change the metrics it reports every six months? Are they talking revenue one half, then NPAT, then underlying EBITDA? One company that subsequently got into financial trouble went so far as to highlight Gross Margin on their press release right before it spiralled out of control — that was the reddest of red flags!
Dig a little deeper
There are often good reasons for a company to report 'underlying' or 'management' earnings. But if management want to exclude so-called 'one-off' expenses that seem to happen every second year, you should treat them with absolute scepticism.
Read the management commentary
What is your CEO telling you? Is it all sweetness and light? Or is she admitting to problems, mistakes and challenges? If they'll give it to you straight in the commentary, there's much less chance that they're dressing up the numbers.
Use the 'sniff test'
This is one of my favourites, and a favoured management approach of some of my best bosses. It's not always the case that common sense leads to the right outcome, but if the whole thing just seems a little 'off', it might just well be. Which leads me to…
If in doubt, leave it out
Maybe you're judging too harshly. Maybe there are good reasons for management to report 'underlying, management EBITDA before adjustments and selected changes'… but there probably aren't. If you feel like something's not right, if you're not sure, or if the financials just seem too complex or opaque, just give that one a pass and move on. There are plenty of fish in the sea.
