The gap between stated and adjusted profits reported for FTSE 100 firms has reached its highest level in 10 years, according to research by AJ Bell.
Using a decade’s worth of accounts and reports for every FTSE 100 listed company, AJ Bell found that the gap between the stated operating profits stated by companies and their adjusted earnings had reached a record high.
With earnings reports a key signal for the value of a company, the growing discrepancy is troubling news for many investors.
There are two potential reasons for this growing gap, according to Russ Mould, the investment director of AJ Bell.
‘Either, companies are simply being more transparent, providing greater clarity to shareholders on the many moving parts which make up their business and enabling investors to get a better view of what is really going on under the bonnet,’ he noted.
Alternatively, he said, it could be that companies are instead ‘intentionally muddying the waters.’
He adds: ‘Some even present sales figures in multiple formats of actual, underlying and underlying in constant currencies. Others point to underlying metrics of their own choosing and publish those figures first in regulatory announcements (while at least flagging that they are not based on generally accepted accounting principles, or GAAP).’
The reason for this would be to put a positive spin on their figures. This may be done to either boost the company’s share price, or alternatively, help management hit targets.
Either way, for investors the research underlines the importance of understanding both how companies profit as well as how they report on these profits.
A large discrepancy between stated and adjusted profits does not always mean a company is a bad investment. However, having a proper understanding of a company’s profits is vital to understanding its competitive position and therefore potential as an investment.
One way to do this is to apply the rule of three when assessing a potential company to invest in.The rule of three states that if sales, operating profit and cash flow all grow consistently and at fairly similar rates, the company is solid and potentially a good investment.
Growth of all three would suggest the company has a strong competitive position, pricing power and a reliable set of accounts. If, however, sales and profit grow but cash flow stumbles, more research into the dynamics of the company may be required.
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