Investors place too much trust in flattering numbers

What’s a profit? A recent ill-tempered television appearance by the co-founder of home-flipper Opendoor Technologies Inc., Keith Rabois, showed just how far we have drifted from a common understanding of earnings.
Rabois, a Miami venture capitalist, was irritated by his interlocutor’s (not unreasonable) suggestion that Opendoor is loss-making. Net losses total $1.7 billion since inception, according to the latest accounts, and the quarter that just ended will likely be ugly due to falling house prices.
But on a “per home basis” — also known as “contribution margin,” which excludes groupwide costs such as marketing and technology development — Opendoor has consistently made money for years, Rabois argued. 1 The clash reflects the extraordinary proliferation of alternative financial performance measures during an era of “free money,” when investors were focused on top-line growth over bottom-line earnings.
Because Opendoor is far from alone. Non-standard financial metrics are widespread in private equity buyouts and among startups that report losses under normal accounting, but they are also used by almost all S&P 500 companies. UK annual reports include 16 such figures on average, according to a survey by the UK’s Financial Reporting Council. One of the favorites is adjusted earnings before interest, taxation, depreciation and amortization, aka “Eventually busted, interesting theory, deeply aspirational.”
Which numbers should investors actually rely upon? It’s increasingly hard to know. While these alternative figures can provide a more complete and meaningful picture than a regular profit and loss statement, they’re not recognized by generally accepted accounting principles (GAAP) or the International Financial Reporting Standards used outside the US. Not surprisingly, they tend to make earnings appear higher than they otherwise would and can even magically turn an accounting loss into an adjusted profit. Remember WeWork’s infamous community-adjusted ebitda, which stripped out swathes of the office provider’s expenses?
The use of these metrics partly reflects how accounting standards haven’t kept pace with changes in the economy, especially the importance of intangible assets. But the danger is investors place too much trust in flattering numbers. Alternative performance metrics aren’t audited as closely. In a recession, the worst offenders might discover that a large “total addressable market” (TAM) and an adjusted profit soup don’t pay the bills.
“Both private and public companies are taking astonishing liberties by misrepresenting their profitability,”says Stephen Clapham, founder of research and training firm Behind the Balance Sheet.
—Bloomberg