Ethan Rouen is an Assistant Professor of Business Administration at Harvard Business School; Eric C. So is the Sloan Distinguished Professor of Management at the MIT Sloan School of Management; and Charles C.Y. Wang is the Glenn and Mary Jane Creamer Associate Professor of Business Administration at Harvard Business School. This post is based on their recent article, forthcoming in the Journal of Financial Economics.
Financial statements contain a wealth of information about a firm’s net income, an estimate of the net value flow during a period. Investors commonly seek to distinguish the component of earnings that stems from a firm’s central business activities (“core earnings”) from those components that result from ancillary business activities or transitory shocks. This exercise is essential for interpreting and forecasting firm performance.
The behavior of sell-side analysts and managers attests to the importance of distinguishing core and non-core earnings. Analysts regularly report and forecast firms’ earnings on a non-GAAP basis (“street earnings”) by excluding from GAAP earnings items deemed transitory or not reflective of the central business activities. Similarly, managers commonly report non-GAAP “pro forma” earnings that exclude items they consider unimportant for understanding firm performance. A concern with these metrics is that managers and analysts choose in a biased fashion which items to include or exclude. For example, pro forma earnings often exclude stock-based compensation expenses, which result from central business activities and are recurring. Excluding these measures help to paint a rosier picture of firm performance.