Reported earnings don't tell the whole story of a company's profits. They are based on accounting rules designed for debt investors, not equity investors, and are manipulated by companies to manage earnings. Only economic earnings provide a complete and unadulterated measure of profitability.
Converting GAAP data into economic earnings should be part of every investor's diligence process. Performing detailed analysis of footnotes and the MD&A is part of fulfilling fiduciary responsibilities.
We've performed unrivaled due diligence on 5,500 10-Ks every year for the past decade.
In the reports we've done so far, we've gone through several of the adjustments we make to reveal a company's core operating profit, or NOPAT. It's important to understand, however, that the removal of income and expenses has an effect on the true taxes a company pays as well. Without removing the tax impact of non-operating items, one still gets a distorted picture of a company's operating profitability.
Due to its high number of non-operating expenses, United Parcel Service (NYSE:UPS) had a low reported income tax expense of only $167 million, and a tax rate of 17.1%. To find its true operating tax rate, we removed the tax benefit (pre-tax value minus post-tax value) of non-operating items where the pre and post-tax values were disclosed (see an example). Removing the tax benefits from the income tax expense and adding the non-recurring expenses back to income gave UPS an effective cash tax rate of 34.8%. Multiply that tax rate by UPS' pre-tax operating profit of $11.5 billion, and you see its true operating taxes are just over $4 billion.
Figure 1 shows the five companies with the largest (gross value) non-operating tax adjustment to NOPAT for 2012.
Figure 1: Largest Positive/Negative Non-Operating Tax Adjustment
Sources: New Constructs, LLC and company filings
These companies are far from the only ones affected by non-operating tax adjustments. In the last fiscal year, 2013 companies had negative adjustments to NOPAT totaling $189 billion as a result of increases in their operating tax rates (relative to their reported tax rates), while 655 companies had positive adjustments to NOPAT totaling $21 billion. Our database contains 32,270 non-operating tax adjustments for a total adjustment value of $1.2 trillion in losses from NOPAT and $325 billion in gains to NOPAT.
A large non-operating tax adjustment can sometimes be a contrary indicator, as in the case of UPS above. UPS had a large negative tax adjustment to NOPAT, but this was primarily because of large non-operating expenses, the removal of which resulted in a net positive adjustment to NOPAT. As a result, UPS still earns our Very Attractive rating.
General Motors (NYSE:GM), on the other hand, has by far the largest negative tax adjustment to NOPAT, and it earns our Dangerous rating. Due to a variety of issues, GM actually had a total tax benefit (income) of nearly $35 billion in 2012. Removing the impact of major non-operating items, like a $27 billion goodwill impairment charge, gives GM a cash operating tax burden of $3.1 billion.
No company is going to have a $35 billion tax benefit long-term. Valuing GM based on that distorted tax number is a recipe for disaster. Due diligence in the footnotes is required to remove the distorting effects of non-operating items and reveal a company's true tax burden.
Sam McBride contributed to this report