Practical analysis for investment professionals
10 August 2011

Is It Déjà Vu All Over Again?

The Wall Street Journal has published a number of articles about Groupon, the ecommerce internet company that is planning to go public. A July 28th article focused on Groupon’s use of a “non GAAP” accounting metric — adjusted consolidated segment operating income (CSOI) — to explain its past performance. Intrigued, I looked up Groupon’s SEC registration statement and found that adjusted CSOI excludes marketing expenses, acquisition-related costs, and stock-based compensation expenses. More importantly, this measure transformed a large and increasing “GAAP” net loss of –$6,916 and –$456,320 (in thousands) in 2009 and 2010, respectively, into large and increasing profit as measured by adjusted CSOI of $3,484 and $60,553 in 2009 and 2010. According to the company “it is an important measure of the performance of our business as it excludes expenses that are non-cash or otherwise not indicative of future expenses.”

This prompted me to examine the SEC registration statement of LinkedIn, another “hot internet company.” Lo and behold, it also uses a “non GAAP” accounting metric — adjusted earnings before interest, taxes, depreciation and amortization, or adjusted EBITDA — to explain its past performance. The primary “tweak” made by LinkedIn to “adjust” EBITDA is to exclude stock-based compensation expense, which includes cost of revenue, sales and marketing, product development, and general- and administrative-related expenses. Stock-based compensation increased by 155% from 2007 to 2008, and 86.5% from 2008 to 2009, and for the nine months ending 30 September 2009 and 2010, it increased by 42.2%. LinkedIn reported “GAAP” net losses in 2008 and 2009 of $4,522 and $3,973 (in thousands), respectively; however, it reported a positive-adjusted EBITDA of $5,461 and $14,651 during the same period.

According to the company, adjusted EBITDA is used to understand and evaluate its operating performance, to prepare its annual budget, and to determine bonuses. Reading about Groupon and LinkedIn’s use of a new “non GAAP” accounting metrics made me think fondly of the “roaring ‘90s” when internet companies routinely used “number of clicks” and “number of page views” as better indications of their current and future profitability than “pesky old GAAP measures” such as revenues and net income.

This brings me to three articles that you should read. In “The Flaws of Our Financial Memory,” an article in CFA Institute Conference Proceedings Quarterly, Joachim Klement, CFA, discusses how most investors have flawed memories of past events and suggests that investors should learn about financial history in order to prevent future mistakes. To illustrates this point, Klement cites “Inexperienced Investors and Bubbles,” a study by Robin Greenwood and Stefan Nagel. Using age as a proxy for investment experience, they studied the run-up to the peak of the technology bubble and found that investment managers in the 25- to 35-year-old age group exhibited trend-chasing behavior and invested more heavily in technology stocks than those in the 45 years of age and older group.

As a result, younger managers outperformed older managers during this period, but older managers dramatically outperformed younger managers after the bubble burst. Greenwood and Nagel attribute this underperformance to the fact that the older managers probably remembered previous bubbles and crises in the market and the resulting pain and trauma. They conclude that “living through a financial bubble or crisis changes investors’ experiences, changes their memories of markets, and also changes the way they invest their money over time.”

Another article you should read is “Analysis of the Dot-com Bubble of the 1990s” by John J. Morris and Pervaiz Alam. The authors examined the relation between the market valuation of companies and traditional accounting information (i.e. the valuation of accounting data) before and after the Dot-com bubble and found that during the bubble, the value relevance of accounting information declined significantly. They attribute this to the fact that during the bubble, many investors questioned the value of traditional (GAAP) accounting and financial information as a proxy for a company’s expected future cash flows since so many companies with no earnings experienced significant increases in their stock prices. As a result, companies began to use other metrics and released “pro forma” financial information, which made their balance sheets look much better and justified their lofty valuations.

The authors found that after the bubble burst the value relevance of accounting information rebounded and was comparable to the period before the bubble. Based on these results, Morris and Alam conclude that many investors (especially those investing in internet companies) behaved irrationally during the bubble since there was very little relation between the prices at which they were investing in a company’s stock and the story told by its financial statements.

As a former business school professor, I used to tell my students that the two most important characteristics of successful investors are “age and experience.” Right now I am glad that I am over 45 and my memory is still intact! Now, can anyone tell me where I can find a “no doc mortgage?”

About the Author(s)
Michael McMillan, CFA

Michael McMillan, CFA, is director of ethics education at CFA Institute, where he is responsible for creating, sourcing, and developing educational content for CFA Institute members and investment professionals in the area of ethics and professional standards. Previously, he was a professor of accounting and finance at Johns Hopkins University’s Carey School of Business and George Washington University’s School of Business. Prior to his career in academia, McMillan was a securities analyst and portfolio manager at Bailard, Biehl, and Kaiser and at Merus Capital Management. He is a certified public accountant (CPA) and a chartered investment counselor (CIC). McMillan holds a BA from the University of Pennsylvania, an MBA from Stanford University, and a PhD in accounting and finance from George Washington University. Topical Expertise: Financial Statement Analysis · Standards, Ethics, and Regulations (SER)

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