August 17, 2017

PANW’s Uniform Adjusted EPS’ is substantially greater than as-reported earnings suggest, and expected to grow materially, implying valuations may be too cheap

  • PANW’s profitability is materially distorted by accounting for R&D and stock option expense
  • As such, their UAFRS EPS’ is expected to be $0.76 in Q4 and $3.03 in the next year, not -$0.45 and -$2.10, respectively, as GAAP accounting metrics report
  • At current valuations, markets are embedding expectations for 21% EPS’ growth annually, which is substantially lower than analyst projections for +50% annual EPS’ growth, warranting material equity upside should the firm meet estimates


Palo Alto Networks (PANW) is expected to release Q4 2017 GAAP EPS of -$0.45 on 8/31, which would represent a $0.16 improvement relative to EPS of -$0.61 in the same period last year. Moreover, full-year estimates are bullish, with projections for EPS to improve by $0.48 in the next four quarters, from -$2.58 in the four-quarter period ended Q3 2017, to -$2.10. Despite such a bullish outlook, shares have fallen considerably in the past year, as PANW’s inability to generate positive GAAP EPS has pressured the firm’s stock price.

However, after making appropriate adjustments under Uniform Adjusted Financial Reporting Standards (UAFRS), it is apparent that although earnings have declined recently, profitability is far higher than traditional EPS implies, and is expected to rebound considerably going forward.

Specifically, under UAFRS, Uniform EPS (EPS’) is actually expected to be $0.76 in Q4, a $2.21 increase from -$1.45 in the same period last year, and is also expected to grow by $2.98 in the next four quarters, following a dramatic $2.32 collapse in the four-quarter period ended Q3 2017. EPS’ is expected to reach $3.03 in the next year, a material rebound from $0.05 in the last year, and a far-cry from the negative EPS levels that GAAP accounting metrics report. This suggests that valuations are much less aggressive than they seem at first glance, and PANW may actually be cheap, not overly expensive.

The quarterly results show a similar trend, with EPS’ expected to remain positive, and well above as-reported EPS going forward, as it has in each of the last three quarters, and, should EPS’ continue to grow as it is expected to, this suggests valuations may be too cheap.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of R&D and stock option expense. Once removed, it is apparent that PANW’s profitability is far greater than as-reported metrics suggest, indicating that the firm is cheaper than as-reported valuations suggest, which can have material implications for shares at current valuations.

UAFRS vs. As-Reported EPS

Investors make major decisions about which companies to own based on quarterly company earnings, the most common metric mentioned in traditional corporate investment analysis.

However, more often than not, the earnings that companies report in any given quarter can swing wildly and lead investors to completely wrong conclusions, because GAAP and IFRS rules force management to report results in ways that are not representative of the real operating performance of the business.

While there is a case to be made that some management teams can use “creative accounting” to adjust numbers, the research would show that more often than not, the real problem is with the accounting rules themselves, not management’s use of them.

The UAFRS Advisory Council has identified over 130 accounting and financial reporting inconsistencies (some of which can be found here), of which several have material impact on PANW’s financials.

Impact of Adjustments from GAAP to UAFRS

Two key UAFRS adjustments have the largest impact on PANW’s income statement, to get from earnings to UAFRS-adjusted earnings. These are related to R&D and stock option expense.

GAAP and to a lesser extent IFRS (which allows for capitalization of a portion of R&D expense) treat R&D investments as expenses, when in actuality these are investments in a company’s future operations. They may be good investments or bad investments, but it’s hard to think of R&D as cost of goods sold.

In the case of R&D expense, this is often a multi-year investment in a firm’s future offerings. Expensing R&D violates the basic matching rule of accounting, that expenses should be recognized in the period the related revenue is recognized.

Expensing R&D can also dramatically increase earnings volatility, as the timing of R&D related to multi-year projects can create lumpy earnings volatility, distorting understanding of a company’s real profitability.

Additionally, PANW has had material non-cash stock option expense since the company was founded. This is treated as an expense to the company in accounting statements, when it is actually a way for the company to give employees an ownership stake in the company. As such, this non-cash expense should be treated as dilution to equity holders and another claim against the Enterprise Value of the firm, as opposed to it being treated as an annual expense. This is especially true as, unless the company uses cash to buy shares (to suppress dilution for equity holders from the option grants being exercised), there is no cash impact on the company.

UAFRS-reporting adjusts for these traditional accounting distortions by treating all R&D as investing cash flows and re-bucketing stock option expense into enterprise value. These simple reclassifications remove a tremendous amount of accounting noise related to investment activities and improves investors understanding of the operating earnings of a business.

Greater-than-reported EPS’ and expectations for growth suggest valuations may be too cheap

At current prices, PANW is trading at a 42.2x traditional forward P/E, which, when considering recently negative as-reported earnings, may indicate an overvalued firm. However, after making the requisite adjustments, it is apparent that the firm is actually trading at a UAFRS-based P/E of 39.5x, which though somewhat high, is well below peers with similar growth prospects.

Specifically, when considering the fact that EPS’ is expected to grow considerably going forward, historically low valuations are unwarranted. At a 39.5x UAFRS-based P/E, markets are embedding expectations for annual EPS’ growth of 21%, which is markedly lower than long-term analyst estimates for +50% annual EPS’ growth. As such, should PANW simply maintain growth in-line with analyst estimates, material equity upside would be warranted.

By using Uniform Adjusted Financial Reporting Standards (UAFRS), investors see a cleaner picture that distorted GAAP and IFRS metrics cannot show. By standardizing financial reporting consistently across time and across companies, corporate performance and valuation metrics improve dramatically. Comparability of a company’s earnings over time, trends in corporate profitability and comparability in earnings power and earnings growth across close competitors and different sectors becomes far more relevant and reliable.

To find out more about Palo Alto Networks, Inc. and how their performance and market expectations compare to peers, click here to access the open beta of the Valens Research database.

Our Chief Investment Strategist, Joel Litman, chairs the Valens Research Committee, which is responsible for this article. Professor Litman is regarded globally for his expertise in financial statement analysis, fundamental research, and particularly Uniform Accounting, UAFRS.