Two from Jeffrey Schwarz:

Yahoo, the Internet search company, reported that it earned $0.05 a share on a pro-forma basis. What is “pro-forma basis”?

Pro-forma means, essentially, “as if” — e.g., in the case of a merger or prospective merger, the results are issued as if the merger had already taken place, and past results are restated to pretend the merger had been in effect all along. In the case of Yahoo, it might mean “as if all the stock options we’ve granted our management and employees were exercised” (also known as reporting earnings on a “fully diluted basis”). Maybe earnings were $6 million on 100 million shares — 6 cents. But what if there are options outstanding on 20 million additional shares? In that case, one might think of the company, and its $6 million in earnings, as realistically being divided up among 120 million shares — 5 cents each.

Please note: I know nothing about Yahoo specifically, other than how to visit its website, and am just making up these numbers for the sake of illustration. Pro-forma, as it were.

Also: what prevents a company from claiming just about everything it purchases is an “investment” [which it can then capitalize over several years rather than charge to earnings right away], thus lowering expenses and increasing earnings? If a company did that, wouldn’t its earnings look artificially high?

Exactly so. What prevents a company from doing this are the independent auditors, who all attempt to follow GAAP (Generally Accepted Accounting Principles) . . . as well as pressure from Wall Street analysts who look to see how aggressive or conservative the accounting has been. But you’re right: there’s real variation in the “quality of earnings” that companies report . . . it’s important . . . and it takes a careful reading of the footnotes, and sometimes more, to find it. A company that “expenses” all its research and development costs, for example, is being a lot more conservative than one that chooses to “amortize” them off over a period of years. Both approaches can be justified, but in comparing two companies, it’s important to compare accounting practices as well.

One reason many investors give weight to “cash flow per share” as an indicator is that it cuts through all this. “Listen buddy,” cash flow says. “Just tell me how much came in and how much you spent. If you took in $10 million more than you spent, I don’t mind so much that you reported a big loss. And if you spent $10 million more than you took in, I’m a little less excited about the huge profit you reported — GAAP or no GAAP.”

GAAP is actually a very logical, painstakingly worked-out set of principles that in many respects can provide a much more thoughtful picture than simple “cash flow.” A smart investor often looks at both.

 

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