By: Mat Lystra, Sr Research Analyst
I picked up the Sunday edition of The New York Times a few weeks ago and noticed a story about a well-known pharmaceutical company. It wasn’t the mention of the company itself that induced my read, but the story’s overarching caution about the use of non-GAAP earnings. In particular, adjusted earnings were the subject of the article, which left me curious about how they might be affecting the membership of the Russell 1000 Index. When I took a closer look, I discovered that using adjusted earnings can indeed have a material impact on the earnings profiles of index constituents.
In the world of indexing we have historically tended not to worry so much about the earnings of individual companies and concerned ourselves more with market capitalization, liquidity, free float, etc. The use of fundamental financial measures is growing, however, as in the proliferating number of “fundamentally weighted” smart beta indexes or the use of medium term IBES earnings growth forecast when determining style (growth and value companies), and EPS variability when determining stability (defensive and dynamic companies).
Earnings generally come in one of three forms: 1) reported earnings, 2) analyst forecasted earnings, and 3) adjusted earnings. The first two underlie the inputs used by FTSE Russell indexes for the purposes of index creation. But again, the third type – adjusted earnings – was the subject of The New York Times article.
Companies may have legitimate reasons for using adjusted figures like EBITDA (earnings before interest, taxes, depreciation and amortization) when a substantial non-recurring charge impairs the reported earnings. But according to The New York Times, the pharma company’s adjusted earnings appeared to be used to systematically overstate the company’s earnings. There are few rules governing what can and can’t be left out of a company’s adjusted earnings and that flexibility gives U.S. companies plenty of room to get creative.
So how are adjusted earnings impacting the membership of the Russell 1000® Index? In 2014 companies in the Russell 1000 had reported earnings of approximately $840 billion but adjusted earnings of nearly $2 trillion – $1.1 trillion gained from taxes and other write offs. Additionally, I took a look at the 2014 fiscal year reported EPS (earnings per share), IBES 1yr forecasted EPS, and EBITDA per share for companies in the Russell 1000 Index. The chart below plots Russell 1000 Index companies’ reported EPS and IBES analyst forecasted EPS – sorted in ascending order – along the horizontal axis, and the corresponding EBITDA per share along the vertical axis. The resulting positive slopes of our two clusters show how using adjusted earnings figures can dramatically impact the earnings profiles of companies in the Russell 1000 Index.
Such an outcome is not surprising – EBITDA by definition should produce a larger result – but as the practice of promoting adjusted earnings becomes commonplace and the race for informational advantage reaches lightning speed, distinguishing GAAP from non-GAAP may get lost as happened with the pharma company in the article.
The same caution applies to index providers as we increasingly rely on fundamental financial measures of corporate performance to satisfy the demand for style, stability and smart beta. These are complex issues but as market participants place increasing weight on a range of underlying company performance data, the best index providers are thinking carefully about how accounting rules can affect outcomes. In other words, we have to mind the GAAP.
Russell 1000 companies look more profitable when using adjusted earnings per share.
Sources: FTSE Russell, FactSet and Compustat as of 12/31/2014.
 Morgenson, G. (2015). Valeant Shows the Perils of Fantasy Numbers. The New York Times, 10/30/2015. Retrieved from: http://www.nytimes.com/2015/11/01/business/valeant-shows-the-perils-of-fantasy-numbers.html?ref=todayspaper&_r=0
 Smart Beta – What You Need to Know. (2014). Retrieved from: http://www.finra.org/investors/alerts/smart-beta
 Ro, S. (2013). Here’s How You Should Think About ‘Adjusted’ Earnings. Business Insider. Retrieved at: http://www.businessinsider.com/gaap-vs-non-gaap-earnings-eps-2013-12
 Pricewaterhouse Coopers (2014). Non-GAAP Financial Measures – Enhancing Their Usefulness. Retrieved at: https://www.pwc.com/us/en/cfodirect/assets/pdf/point-of-view-non-gaap-financial-measures.pdf
 Compustat data for 2014 where companies reported both EBITDA and Net Income within the Russell 1000 Index.
 EBITDA was used as a proxy for adjusted earnings.
 Rapoport, M. (2015). What Companies Strip Out of ‘Non-GAAP’ Earnings: Fines, Exec Bonuses, Severance, Rebranding Costs…The Wall Street Journal. Retrieved from: http://blogs.wsj.com/moneybeat/2015/01/08/what-companies-strip-out-of-non-gaap-earnings-fines-exec-bonuses-severance-rebranding-costs/
© 2016 London Stock Exchange Group companies.
London Stock Exchange Group companies includes FTSE International Limited (“FTSE”), Frank Russell Company (“Russell”), MTS Next Limited (“MTS”), and FTSE TMX Global Debt Capital Markets Inc (“FTSE TMX”). All rights reserved.
“FTSE®”, “Russell®”, “MTS®”, “FTSE TMX®” and “FTSE Russell” and other service marks and trademarks related to the FTSE or Russell indexes are trade marks of the London Stock Exchange Group companies and are used by FTSE, MTS, FTSE TMX and Russell under licence.
All information is provided for information purposes only. Every effort is made to ensure that all information given in this publication is accurate, but no responsibility or liability can be accepted by the London Stock Exchange Group companies nor its licensors for any errors or for any loss from use of this publication.
Neither the London Stock Exchange Group companies nor any of their licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE Russell indexes or the fitness or suitability of the indexes for any particular purpose to which they might be put.
The London Stock Exchange Group companies do not provide investment advice and nothing in this article should be taken as constituting financial or investment advice. The London Stock Exchange Group companies make no representation regarding the advisability of investing in any asset. A decision to invest in any such asset should not be made in reliance on any information herein. Indexes cannot be invested in directly. Inclusion of an asset in an index is not a recommendation to buy, sell or hold that asset. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the London Stock Exchange Group companies. Distribution of the London Stock Exchange Group companies’ index values and the use of their indexes to create financial products require a licence with FTSE, FTSE TMX, MTS and/or Russell and/or its licensors.
The Industry Classification Benchmark (“ICB”) is owned by FTSE. FTSE does not accept any liability to any person for any loss or damage arising out of any error or omission in the ICB.
Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back- tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.