One of the most important truisms of investing is that stock prices follow earnings. Follow this rule and you’ll find success as an investor.
Unfortunately, most investors make a huge mistake in getting their earnings data from crackpot financial reporters that have no fundamental understanding of how companies manipulate data.
You see, most investors remain unaware that companies effectively maintain two sets of books. The first contains a comprehensive report of the company’s performance according to generally accepted accounting practices, or GAAP, for short. These results are required to be submitted to the SEC once a quarter, and require the signature of the chief executive.
The second set is for fun. Well, not really…
The second set is often referred to as “pro forma” or adjusted results. Here a company can report their financial results to investors that contain ‘adjustments’ to the real results. And as you might expect, these adjustments are used to make the company appear more profitable than their results indicate.
Now, I’m not saying there is never a good reason to make adjustments to a company’s results. There are times when a company is taking one-time expense for layoffs or plant closings, etc. Since these costs won’t recur every year, it’s perfectly acceptable to make the adjustments.
The problem is that some companies have a history of abusing the rules allowing them to make adjustments on items that aren’t one-time expenses. One such company is Salesforce.com (NYSE: CRM).
Salesforce.com frequently claims ‘one-time’ adjustments to expenses that are reported every single quarter. In their most recent 10-Q filing, the company reported that they lost $26 million in 4Q2015.
This should have put downward pressure on the stock price. But that didn’t happen…
In fact, the stock rose more than 10.2% on heavy volume to close at $69.42 per share on Thursday. What accounts for the increase after the earnings decline?
The company adjusted its earnings to remove the cost of stock options it granted to its employees, which cost the company more than $159 million. And by eliminating the options costs, the company could magically report to investors that it earned $133 million in the quarter instead of the loss as reported to the SEC.
This is what gunned the stock higher.
But it’s a fraud. Employee compensation is a normal cost of doing business, and to treat it as a one-time expense is nothing short of dishonest. The company did it to make investors believe that management successfully grew their earnings in the quarter. And to hide the fact the company rewarded its employees with all of the company’s profits in the quarter.
Warren Buffet’s right hand man, Charlie Munger, has famously described adjusted earnings as “bullshit earnings.” And he’s right.
If you want to be a better stock picker, you need to pay attention to earnings. And the real earnings, not the earnings reported by ethically challenged corporate executives or incompetent financial journalists.
Everything else is a warm pile of B.S.