Warren Buffett is highly critical of adjusted earnings because it allows companies to disregard relevant expenses. For example, acquisition and restructuring related expenses are often excluded from adjusted net income numbers. However, for companies that are frequently acquiring other companies, those acquisition costs become a dumping ground for whatever the acquirer can put in there and keep away from its adjusted earnings.
The problem is that when you hear of a company beating its earnings, it’s normally in relation to adjusted earnings, not GAAP net income. While net income can be skewed by gains and losses and other non-operational items, adjusted earnings are not much more helpful.
When it comes to net income, you can have some assurance that everything is included in that number per GAAP rules. However, adjusted earnings is a non-GAAP measure and that allows companies to manipulate their earnings by deciding what is or isn’t an acquisition cost or some other expense that won’t count towards adjusted earnings.
This creates a problem for investors because the figures can easily be misleading and paint a very different picture from reality.
It’s for this reason that I like to focus on a company’s operating income, since it offers a bit of both worlds. It’s not far enough down the income statement that it will include non-operational items or gains and losses, and it’s a GAAP number that will provide you with some consistency and reliability.
It’s always important to dig into the financial results yourself to assess whether a company did well or not, rather than relying on whether it ‘beat’ expectations.
