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 unrivalled due diligence on 5,500 10-Ks every year for the past decade.
Most adjustments we have discussed thus far can only be found by performing careful footnotes research, but some of the adjustments we make use items commonly found in a company's financial statements. We tend to write more on the footnotes items because we find them more interesting. Nevertheless, quite a bit of work has to be done to clean up income statements as well.
Income statement adjustments include financing items like interest expense/income, preferred dividends and minority interest income. These items are related to the financing of a company's operations, not the operations themselves. We always calculate NOPAT on an unlevered basis.
Other income statement adjustments include any unusual income or expense, such as a gain on sale or restructuring charge.
Many times, unusual gains and expenses are found on the income statement as well as the footnotes or MD&A. You never know unless you look.
For instance, Yahoo (YHOO) earned $4.6 billion from selling its shares of Chinese e-vendor Alibaba and $44 million in interest, investment and other income. The $4.6 billion gain is offset by $236 million in restructuring charges, leaving $4.4 billion in income that the company classifies as non-operating but still includes in GAAP net income. We remove these non-recurring items for our NOPAT calculation to get a picture of the core profitability of the company.
Figure 1 shows the five companies with the largest positive and negative NOPAT adjustment for reported non-operating items in 2012.
Figure 1: Companies Most Affected By Reported Net Non Operating Items in 2012
Sources: New Constructs, LLC and company filings
These companies in Figure 1 are far from the only ones affected by reported non-operating items. In the last fiscal year, we removed 12,935 non-operating items. 2,134 companies had positive adjustments totaling over $454 billion and 422 companies had negative adjustments totaling nearly $39 billion. Going back to 1998, we've found 138,717 non-operating items with positive adjustments to companies totaling over $3.8 trillion and negative adjustments of $500 billion.
The removal of non-operating expenses can increase NOPAT and make a stock look undervalued. For example, Hewlett Packard (HPQ) had over $22 billion in reported non-operating expenses in 2012. These include $18 billion in write-downs (reported on the income statement rather than hidden in operating earnings), $2.3 billion in restructuring charges, $876 million in interest and other expenses, and $46 million in acquisition-related charges. HPQ reported GAAP earnings of -$12.7 billion for 2012, but removing these non-operating items helped bring its NOPAT to positive $7.6 billion. These adjustments drove our Attractive rating for HPQ, which is up 46% so far this year.
Due diligence in the financial footnotes is key, but it's not enough for investors to scan the footnotes if they don't know how to analyze the income statement. Adjusting out the non-operating items disclosed on the income statement gives a truer picture of a company's profitability and can reveal when a company is over or under valued. Diligence pays.
Sam McBride and André Rouillard contributed to this report
Disclosure: David Trainer, Sam McBride and André Rouillard receive no compensation to write about any specific stock, sector, or theme. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.