beginners corner

GAAP versus Non-GAAP Earnings: Challenges of Fundamental Analysis

Fundamental analysis is the first step when screening stocks for covered call writing and put-selling. Years ago I actually read the financial statements of companies I was interested in.  I eventually came to the conclusion that this was an exercise in futility as it was time-consuming and, in many cases, difficult to confirm the accuracy of my analysis. Different companies used different accounting measures and sometimes one company used different measures from quarter-to-quarter to “dress-up” the quarterly reports. I know it’s hard to believe that this type of hanky-panky actually goes on (he said sarcastically). As a result, the BCI methodology uses several screens that include fundamental analysis as a triple-check on these accounting procedures:

  • IBD 50
  • IBD Smart Select
  • Scouter Risk/Reward (the BCI team is now accessing Scouter stats for our premium members but they are not currently available to the public)

The screenshot below shows the three areas where fundamental screening takes place in our Premium Stock reports (two arrows and brown-highlighted cells):

stock selection for covered call writing

Premium_Report: Fundamental Analysis

 

As an example of varying accounting measures, Earnings-Per-Share (EPS) can be based on the number of shares outstanding (Basic) or on Diluted EPS which adds in options, warrants and convertible debt to the number of shares in the denominator. The latter is the more commonly used statistic. In this article, we will focus on GAAP versus Non-GAAP earnings and make a case why multiple resources should be used when evaluating and comparing a company’s financial health.

 

What is GAAP earnings?

GAAP is an acronym for generally accepted accounting principles. It includes things like revenue recognition, expense matching (reporting expenses and revenues in same period) and accrual accounting. Although standardization of reporting makes good sense, it may not always tell the full story when there are unusual, non-recurring revenues or expenses as with depreciation or restructuring of a corporation.

 

What is non-GAAP earnings?

This is when earnings are reported before interest, taxes, depreciation and amortization (paying off debt) to get a more accurate picture of a company’s cash-flow, especially since depreciation is a non-cash expense.

Other names for non-GAAP adjustments

  • One-time items
  • Extraordinary items
  • Non-recurring charges/gains
  • Adjustments

Other names for non-GAAP earnings

  • Pro forma earnings
  • As-adjusted earnings

 

What is the role of the SEC regarding reporting of earnings?

The Securities and Exchange Commission requires that companies that report non-GAAP earnings also report the comparable GAAP financial statistics. The challenge for retail investors like us is to discern how the company arrived at the non-GAAP earnings figures. It is not practical to expect retail investors to navigate through these earnings reports and make accurate determinations. As an alternative approach, the BCI methodology uses the three screens alluded to earlier in this article as a triple check on fundamental analysis. Another way to accomplish this (for non-members) is to use a quality screen, enter a series of fundamental parameters (free cash flow, return on equity among others) and generate a list of top-performers from a fundamental perspective. An excellent free site for this is:

www.finviz.com

***My book, Stock Investing for Students, Chapter 2 lists a series of generally accepting fundamental parameters used to identify companies that are financially strong and healthy

Discussion

Fundamental analysis is the first critical step used in the BCI methodology for stock screening. Earnings can be determined from a GAAP or non-GAAP perspective. This, among other accounting differences used by companies, makes if challenging for retail investors to evaluate earnings reports so it is essential we used multiple screens to double and triple-check the accuracy of our fundamental analysis.

 

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To register, login to the member’s site and scroll down on the left side below the store discount link. Then click on the Blue Hour sign-up link and fill out the short registration form. For members who cannot attend the event live, my team will be recording the webinar and it will be posted on the member site the following week.

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___________________________________________________________________

Market tone

Global stocks moved higher again this week despite geopolitical events in Turkey. The market is preparing for the potential for easing of the monetary policy from the Bank of Japan next week and perhaps from the European Central Bank in September. Oil prices declined this week and The Chicago Board Options Exchange Volatility Index (VIX) was static at 12.62, up from 12.52 last week. This week’s reports and international news of importance:

  • Turkish president Recep Tayyip Erdogan declared a three-month state of emergency in the wake of a failed coup attempt last weekend. Standard & Poor’s downgraded Turkey’s sovereign debt rating this week to BB from BB+
  • Britain’s investor confidence index dropped sharply in July, reflecting concerns that the United Kingdom’s decision to leave the European Union will weaken the European economy
  • The International Monetary Fund trimmed 0.1% from its March forecasts for global gross domestic product growth. The IMF now expects the global economy to grow 3.1% this year and 3.4% next year, blaming uncertainty surrounding Brexit for the slower growth
  • The flash reading of the July Markit composite purchasing managers’ index dropped sharply due to the United Kingdom’s vote in late June to leave the European Union. Markit chief economist Chris Williamson expects the UK economy to contract 0.4% in Q3

THE WEEK AHEAD

  • G20 officials meet in Chengdu, China on Saturday and Sunday, July 23rd to the 24th
  • The Federal Open Market Committee meets to set interest rates on Wednesday, July 27th
  • The Bank of Japan meets to set interest rates on Thursday and Friday, July 28th to the 29th
  • Revised Q2 US gross domestic product figures are released on Friday, July 29th

For the week, the S&P 500 rose by 0.61% for a year-to-date return of +6.41%.

Summary

IBD: Market in confirmed uptrend

GMI: 6/6- Buy signal since market close of July 1, 2016

BCI: Moderately bullish. I’m favoring out-of-the-money strikes 2-to-1 as earnings season has been decent thus far

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The charts continue to point to a bullish short-term outlook. In the past six months the S&P 500 rose by 15% while the VIX declined by 55%, an impressively bullish picture.
______________________________________________________
Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)

 

 

 

 

 

 

 

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

26 Responses to “GAAP versus Non-GAAP Earnings: Challenges of Fundamental Analysis”

  1. Jay July 23, 2016 9:36 pm #

    Alan,

    Oh, the lazy days of summer….

    With the VIX this low it is tempting to nap under the nearest tree. Why cover stocks for a pittance at these IV levels?

    That sentiment will lkely take the market down and make one wish they sold covered calls for August! -Jay

    • Alan Ellman July 24, 2016 5:57 pm #

      Jay,

      Another way to look at it is that even a 1-2% 1-month return is the equivalent of holding on to a CD for 1-2 years. Also, a low VIX implies less market risk. I say the glass is half full.

      Alan

  2. Barry B July 24, 2016 12:12 am #

    Premium Members,

    This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor Premium Member site and is available for download in the “Reports” section. Look for the report dated 07/22/16.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:

    http://www.youtube.com/user/BlueCollarInvestor

    Since we are in Earnings Season, be sure to read Alan’s article,
    “Constructing Your Covered Call Portfolio During Earnings Season”. You can
    access it at:

    https://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/

    Best,

    Barry and The BCI Team

  3. Adrian July 25, 2016 4:07 am #

    Hi Alan, it has been a while that I was here last since I had to sort out my tax again- it’s the time of year for this!
    I still have plenty of things to find out and confirm so here I have my first 5 questions.

    1. Is it a good idea to periodically compare the market performance chart to all my stocks(like once per week), to see if the stocks are turning to underperform the market?, if I do and I do see that they are starting to underperform then should I immediately close and sell my position in any stocks that display this?

    2. If it still holds that an ATM return which is greater than 7% for a bullish market is best avoided, then what if this was over a 5-week contract instead?,- would you work out the return for 4 weeks to see if the return is not more than 7%, & if so then reconsider not using it?

    3. After a stock has risen alot but not enough for a MCU but then starts falling, you say to check the ‘cost to close’ price to compare it to the share loss, to find out which is less.
    Can you give me a trade example to explain how you mean?
    (I needed to go over this again because I need to see a working type method for better clarity.)

    4. After putting in a BTC limit order(or maybe a OTO order) the night before, then isn’t it possible for the order to be filled the next morning before 11am?

    5. I need to also ask what are we to do when there is a power-cut and need to trade?, – I ask this because it happened to me the other night and thanks to the storm I couldn’t use my computer.(do we all need backup generators?, what do you do?)

    I am going to email you some of my promised questions on the calculations for which I didn’t get around to doing weeks back.
    Thanks for the help.

    • Alan Ellman July 25, 2016 3:21 pm #

      Adrian,

      Here are the first 2 responses:

      1- In normal market conditions, a stock under-performing the market will have a tough time earning their way onto our premium watch lists. However, in a strong bull market a stock may be under-performing the market and still a good candidate. I would say that if a stock is already in your portfolio and meets our system criteria I would consider retaining the stock even if it under-performing the market. If we are looking for a new stock to populate our portfolio I would look for candidates beating the market.

      2- A 4-week return would annualize to 91% and a 5-week return would annualize to 72.8%. To get these annualized returns we must deal with securities with very high implied volatility whether 4 or 5 weeks. These would be most appropriate in strong bull markets and risky in normal to bearish market environments.

      Will get back to you on the others.

      Alan

      • Alan Ellman July 27, 2016 10:49 am #

        Adrian,

        3- The MCU strategy is appropriate when the time value is approaching zero (when strikes moves deep in-the-money). If the time value remains significant while the strike is in-the-money, there is no need to take action until possibly as expiration approaches. As an example, AAPL gapped up today from a positive earnings report. See the screenshot below showing a ‘buy” price for the $90 strike at $13.50 while AAPL is trading at $103.43. This means the cost-to-close is $7 per contract. I’d jump all over that!

        4- Yes, likely as a matter of fact. However, when we are in front of our computers, I prefer to avoid the early morning and late afternoon volatility of the institutional computerized trading so I trade between 11 AM and 3 PM whenever possible except when rolling options when I may trade between 3 PM and 4 PM on expiration Friday.

        5- Make sure your broker offers phone support in these kind of emergencies…most do.

        CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG

        Alan

    • Roni July 28, 2016 11:59 am #

      You need a good no-break for your computer and modem.
      Also you may have a fully charged laptop and 4G connection.
      I have all these because here where I live (Brazil) we have power-cuts every other day.
      Good luck

      Roni

  4. Tee July 25, 2016 11:55 am #

    hi alan,

    i’m new to stock options and have been following your website. i find it informative and interesting. however i notice there are many strategies in options for eg vertical spread etc but you only focus only on CC. assume a person has some stocks for eg INTC and interested to do CC but if one day it got called away then he will not have the underlying stocks to do CC in the future. he may buy but then if the stock declines then his portfolio will be impacted, so my question is that is CC strategy worth it?

    i’m looking for a safe conservative and passive income so can CC fit into this mindset?

    thanks

    tee

    • Alan Ellman July 25, 2016 3:25 pm #

      Tee,

      Covered call writing is considered by many the most conservative of the option strategies. Brokerages assign the lowest level of trading approval to this strategy and the US government allows us to use covered call writing in our self-directed IRAs. That said, all strategies that look to achieve higher than a risk-free return (like US Treasuries) have some degree of risk attached to them. Our objective is to maximize our returns and minimize our risk and that is what the BCI methodology is all about.

      Alan

  5. Paul July 26, 2016 1:12 am #

    Alan, I just started following some of your Youtube videos which are great by the way.

    I have a question that I hope you could help with. I had just purchased call options that unfortunately had an earnings release on NFLX and it went the wrong way on me.

    Purchased call option on 100 strike for 4.955 pre-earnings actually day of earnings (big mistake) this is for the NFLX Aug05’16 and so the stock plummeted after hours that same day, the option is worth 0.06 right now so I have an unrealized loss.

    I wonder if you would recommend rolling this into the future let’s say Sept. Oct or Nov or Dec?

    My loss is huge and I do think that NFLX should recover.

    I would kindly appreciate your expertise on this and your opinion.

    • Alan Ellman July 26, 2016 7:39 am #

      Paul,

      I cannot give specific financial advice in this venue but I can make general comments you may find useful.

      Since you are on the “buy side” of these options, there is a cash debit whenever you take action. The question becomes should more cash be put into a particular underlying. If bullish about a stock, then that may make sense. If bearish, why not look for an underlying in which we are bullish. If we lose money in position A, that is not a reason to lose more money in position A but rather a reason to be motivated to move into position B. The stock or ETF itself does not matter…it’s the cash we are about to invest that is of utmost importance. Where should that cash be placed?

      Better days ahead…

      Alan

  6. Lee July 26, 2016 2:30 am #

    Hi BCI:
    Do you have any part of your news letter focusing on just selling put ( Cash Secured put).
    Do you make any recommendation on cash secured put in your news letter?
    Thanks

    • Alan Ellman July 26, 2016 7:44 am #

      Lee,

      Yes, both premium member reports (stock and ETF) can be used to select underlying securities for selling cash-secured puts. The appropriate underlyings for put-selling are precisely the same as those that would make outstanding candidates for covered call writing so the lists can be utilized for both strategies.

      These are stocks and ETFs that have passed the rigorous BCI fundamental, technical and common sense screens and contain a significant amount of additional information (beta, dividend info, open interest etc.) that helps our members make final investment decisions.

      Alan

  7. Tom July 26, 2016 10:55 am #

    Alan can you collect dividends if you have the Leaps but don’t own the stocks?

    Do you have an video regarding this question? No hurry I was just wondering.

    Thanks,
    Tom

    • Alan Ellman July 26, 2016 12:54 pm #

      Tom,

      Share holders, not option holders, capture dividends. One of the differences between covered call writing and put-selling is that covered call writers (also share owners) capture dividends while put-sellers do not. However, because share price decreases by the dividend amount on the ex-dividend date, call options are worth less than corresponding put options since puts benefit from share depreciation while calls decline in value.

      Alan

  8. Anoop July 26, 2016 12:09 pm #

    Alan

    Thanks for valuable insights. I have a question, when we buy stocks per your recommendation for a week, should we look to buy contract “Sale to Open” for end of that week or four week from the recommendation i.e. end of month? For example, if I buy NVDA today should I buy covered calls for Aug 18th or July 29th? I am confused, please help.

    thanks
    Anoop

    • Alan Ellman July 27, 2016 6:25 am #

      Anoop,

      The expiration date for the options we sell depend on our trading style…Weeklys or Monthlys There are pros and cons to each and there is a file with those advantages and disadvantages in the ‘resources/downloads” section of the member site. My preference is Monthlys but we do have members who use Weeklys.

      Both our stock and ETF reports highlight where to locate those securities that have Weeklys associated with them…there are hundreds but there are thousands with Monthlys. One of the slides I will be showing during tomorrow night’s webinar addresses Weeklys.

      Alan

  9. Lee July 27, 2016 6:04 am #

    Alan:

    Watched all your video. Do we use the same list for cash secure put as covered call list.

    Do you give a entry price for cash secured put?

    Thanks

    Lee

    • Alan Ellman July 27, 2016 5:48 pm #

      Lee,

      Yes, the list of eligible candidates for covered call writing and selling cash-secured puts is precisely the same. Strike price selection is based on:

      1- Overall market assessment
      2- Chart technicals
      3- Personal risk-tolerance
      4- Goals such as income or buying a stock at a discount

      See pages 89 – 106 in my book “Selling Cash Secured Puts” for detailed information non this topic.

      Alan

  10. Alan Ellman July 27, 2016 5:44 pm #

    Premium members:

    This week’s 8-page report of top-performing ETFs has been uploaded to your premium site.

    Tomorrow’s 1st ever Blue Hour webinar:

    Six seats remain- login to the member site and scroll down on the left side of the member page to register

    For your convenience, here is the link to login to the premium site:

    https://www.thebluecollarinvestor.com/member/login.php

    NOT A PREMIUM MEMBER? Check out this link:

    https://www.thebluecollarinvestor.com/membership.shtml

    Alan and the BCI team

  11. Adrian July 28, 2016 2:12 am #

    Alan, I think you may have mis-interpreted the 3rd question, because it was if any stock rose up a lot, but the calculation isn’t just quite enough to do a MCU. Then typically the stock then starts to fall.
    How do I know whether it is a good idea to close-out this stock for a profit or not?
    As you said to “compare the cost to close price to the share loss”, but how do I do that?(use the AAPL example if you want)

    I think your answer No.1 finally explains it for me, that if I prefer to use the RS-line to compare the stocks performance to the market, then I should only buy stocks where the RS-line is either uptrending or going up-s/ways, but not s/ways alone – otherwise the stock would only be equalling market performances.(I have been backtesting this indicator for months to see the different stock results, but from your view I probably won’t need to for much longer, so thanks for that too.)

    Hope the fees are the same if we do ring up the broker. Thanks

    • Alan Ellman July 30, 2016 7:39 am #

      Adrian,

      In this hypothetical the following is true:

      1- We have maximized our initial position generating option premium + any share appreciation from purchase price to strike if an OTM strike was sold.

      2- The stock price is well above the strike but is now declining.

      3- You are looking for a guideline as when to close a position.

      In the BCI methodology, we close the position mid-contract as the time value component of the option premium approaches zero. By closing and having (nearly) the same amount of cash available, we can now enter a 2nd covered call position in the same month with the same cash.

      Here is the guideline you may be looking for:

      If we can generate more premium in a 2nd covered call position in the remaining weeks of the contract than the cost to close (time value of original option + commissions) than we should close. If not, no action is needed and all other exit strategy opportunities are in play especially looking at rolling possibilities as expiration approaches in the latter part of the contract.

      Alan

  12. Alan Ellman July 28, 2016 6:02 am #

    Premium members: Blue Hour webinar is “sold out”:

    Tonight’ s free webinar has reached its room capacity (which was doubled from the original maximum seating). My team will be recording the presentation and it will available on the premium member site next week.

    TOPICS:

    1- Overview of covered call writing
    2- Portfolio overwriting
    3- Q&A: your written questions answered in real time by Barry Bergman
    4- Q&A: I have selected several questions you have submitted as part of the presentation…added another this morning.

    Thanks for your continued amazing support.

    Alan

  13. Alan Ellman July 29, 2016 6:52 am #

    Last night’s Blue Hour webinar: Premium members

    Last night’s Blue Hour webinar was a “first” for the BCI team. We worked very hard to have it launched flawlessly but like many “firsts” we did have a glitch. I asked my tech team to research why we did have several members who could not login while so many others could. I have asked to see if we can arrange to just have a link and not require a login for future Blue Hour webinars.

    I apologize for this inconvenience but I do have good news. The presentation was recorded and will be available to ALL premium members to enjoy as many times as desired. It will located in the “Blue Hour” section of the member site (scroll down on the left side). I’ll send out email notification when the video is available.

    For those who attended the event we did receive and appreciate your generous and positive feedback…thanks for taking the time.

    The next Blue Hour webinar will be in about 2 months…specifics to come.

    CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG

    • Roni July 29, 2016 1:12 pm #

      No problem Alan,
      I will watch the video when it is available, and will participate in the next blue hour.

      Roni

  14. Roni July 29, 2016 1:19 pm #

    PS – I believe it was my fault.
    I should have downloaded immediately when I got the link in the message of 07/09 from mcssl.com.
    I did not realize that it would expire.

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