Adjusted current p e ratio

What Is Adjusted Current P/E Ratio?

The Adjusted Current P/E Ratio is a financial valuation metric that refines the traditional Price-to-Earnings Ratio by modifying the "earnings" component to account for non-recurring or unusual items. It falls under the broader category of Valuation Metrics within Financial Ratios, aiming to provide a clearer view of a company's sustainable earnings power. Unlike the standard P/E ratio, which uses reported Earnings Per Share (EPS) directly from the Income Statement, the adjusted current P/E ratio seeks to normalize earnings by removing extraordinary gains or losses, or by making other management-defined adjustments. This adjustment is performed to help investors and analysts assess a company's profitability based on its core operating activities, free from distortions caused by one-off events. The Adjusted Current P/E Ratio provides a more consistent basis for comparing companies and evaluating market sentiment.

History and Origin

The concept of "adjusted earnings" and, by extension, the Adjusted Current P/E Ratio, evolved as companies increasingly began to present financial metrics beyond those prescribed by Generally Accepted Accounting Principles (GAAP). These supplementary disclosures, often referred to as Non-GAAP Financial Measures, gained prominence as companies sought to highlight their operational performance without the impact of certain accounting treatments. The Securities and Exchange Commission (SEC) has provided extensive guidance over the years to ensure that these non-GAAP measures are not misleading and are reconciled to their most directly comparable GAAP measures. For instance, the SEC has periodically updated its Compliance and Disclosure Interpretations (C&DIs) regarding non-GAAP financial measures, with a significant update occurring in December 2022 to provide further guidance on what might be considered misleading adjustments, such as excluding normal, recurring cash operating expenses.⁴ This regulatory oversight underscores the importance of transparency when presenting adjusted earnings figures, impacting how the Adjusted Current P/E Ratio is derived and understood.

Key Takeaways

• The Adjusted Current P/E Ratio attempts to normalize a company's earnings by excluding non-recurring or unusual items, providing a clearer picture of core profitability.
• It is a Valuation metric used to assess whether a stock's price is reasonable relative to its sustainable earnings.
• The "adjustments" made to earnings can vary widely and are often defined by company management, requiring careful scrutiny by investors.
• This ratio helps in comparing companies on a more level playing field, especially those operating in different industries or undergoing significant one-time events.
• Interpreting the Adjusted Current P/E Ratio requires understanding the nature of the adjustments and their impact on future Profitability.

Formula and Calculation

The formula for the Adjusted Current P/E Ratio is a modification of the standard Price-to-Earnings Ratio:

Where:

• Current Share Price: The market price of one share of the company's stock at a given time.
• Adjusted Earnings Per Share (EPS): This is the company's reported earnings per share, modified by adding back or subtracting specific items deemed non-recurring, non-cash, or outside of the company's core operations. Common adjustments might include:
  • Exclusion of one-time gains or losses (e.g., asset sales, legal settlements).
  • Exclusion of restructuring charges.
  • Exclusion of impairment charges.
  • Adjustments for stock-based compensation expenses.
  • Adjustments for non-cash expenses like amortization of intangible assets.

The aim is to arrive at a figure that reflects the company's underlying, ongoing earning power, which is a key component for assessing Shareholder Value.

Interpreting the Adjusted Current P/E Ratio

Interpreting the Adjusted Current P/E Ratio involves evaluating the company's stock price against its normalized earnings. A lower Adjusted Current P/E Ratio might suggest that the stock is undervalued, while a higher ratio could indicate that it is overvalued, relative to its peers or its own historical average. However, context is crucial. Different industries typically have different average P/E ratios, and growth companies often command higher ratios due to expectations of future Profitability.

Analysts use the Adjusted Current P/E Ratio to gauge how much investors are willing to pay for each dollar of a company's sustainable earnings. By stripping out one-off events that might inflate or deflate reported Earnings Per Share, this ratio provides a more stable and comparable metric for investment decisions. It helps in assessing a company's operational efficiency and its ability to generate consistent income, which is particularly useful when performing cross-company comparisons or evaluating performance across different phases of the Business Cycle.

Hypothetical Example

Consider two hypothetical companies, TechCo and RetailCorp, both trading at $100 per share.

TechCo:

• Reported EPS: $5.00
• One-time gain from patent sale: $1.00 per share
• Adjusted EPS: $5.00 - $1.00 = $4.00
• Adjusted Current P/E Ratio: $100 / $4.00 = 25x

RetailCorp:

• Reported EPS: $4.50
• One-time restructuring charge: $0.50 per share
• Adjusted EPS: $4.50 + $0.50 = $5.00
• Adjusted Current P/E Ratio: $100 / $5.00 = 20x

In this example, while TechCo initially appears to have higher reported earnings, its Adjusted Current P/E Ratio of 25x is higher than RetailCorp's 20x. This indicates that investors are paying more for each dollar of TechCo's core earnings compared to RetailCorp. The adjustment makes RetailCorp look more attractive from a valuation perspective, as its core earnings power is higher than initially suggested by its reported EPS distorted by a one-time expense. This exercise is part of thorough Financial Reporting analysis.

Practical Applications

The Adjusted Current P/E Ratio is widely used in various facets of financial analysis and investing. Investors and analysts employ it to perform more accurate company comparisons, especially when companies report significant non-recurring items that can skew their GAAP earnings. For instance, in an earnings season, where companies often highlight "adjusted" profits, understanding these adjustments is key to discerning true operational performance.³

It is also crucial for equity research, where it helps determine if a stock is trading at a fair price relative to its fundamental earning capacity. Portfolio managers might use it to identify undervalued stocks or avoid overvalued ones, influencing their decisions on Market Capitalization allocations. Furthermore, economists and policymakers might consider adjusted corporate profits, which form the basis of adjusted P/E ratios, when analyzing overall economic health. Data from the U.S. Bureau of Economic Analysis (BEA) provides aggregate corporate profits, serving as a macroeconomic context for understanding individual company earnings.² For example, when evaluating Capital Expenditures and future growth prospects, a company's consistently strong adjusted earnings can signal greater capacity for reinvestment.

Limitations and Criticisms

While the Adjusted Current P/E Ratio aims to provide a clearer view of earnings, it is not without limitations and criticisms. The primary concern lies in the subjective nature of the "adjustments" themselves. Management has discretion over which items to exclude or include in their adjusted figures, potentially leading to a portrayal of earnings that is more favorable than reality. Critics argue that some "non-recurring" items, such as restructuring charges or integration costs from acquisitions, can occur frequently enough to be considered part of a company's normal operating expenses. If these recurring expenses are consistently excluded, the Adjusted Current P/E Ratio might perpetually overstate a company's true Profitability.

Furthermore, the lack of standardization in these adjustments across companies and industries makes direct comparisons challenging, even with an adjusted metric. Investors must meticulously examine a company's Cash Flow Statement and the detailed footnotes in its Financial Reporting to understand the nature of the adjustments made. Over-reliance on adjusted figures without cross-referencing against GAAP numbers and actual cash generation can lead to misinformed investment decisions. Regulatory bodies like the SEC continuously monitor the use of Non-GAAP Financial Measures due to these potential for manipulation or misrepresentation.

Adjusted Current P/E Ratio vs. Cyclically Adjusted Price-to-Earnings (CAPE) Ratio

The Adjusted Current P/E Ratio and the Cyclically Adjusted Price-to-Earnings (CAPE) Ratio both seek to normalize earnings for a more insightful valuation, but they do so in fundamentally different ways and for different purposes.

The Adjusted Current P/E Ratio focuses on qualitative adjustments to the most recent earnings. It aims to strip out unusual, one-time events (like asset sales or large legal settlements) from a company's reported Earnings Per Share to highlight its ongoing operational profitability. These adjustments are typically made by management and reported alongside GAAP figures, reflecting a company's current earning power free from specific distortions.

In contrast, the Cyclically Adjusted Price-to-Earnings (CAPE) Ratio, popularized by economist Robert Shiller, focuses on quantitative adjustments over a long period. It takes the current stock price and divides it by the average of ten years of inflation-adjusted earnings. The primary purpose of the CAPE ratio is to smooth out the effects of the Business Cycle on earnings, providing a long-term, macroeconomic valuation signal, particularly for broad market indices. Shiller's data, available on his Yale University website, illustrates how this ratio provides a historical perspective on market valuation extremes.¹

The confusion often arises because both ratios involve "adjusting" earnings. However, the Adjusted Current P/E Ratio is a single-period, company-specific metric focused on non-recurring events, while the CAPE Ratio is a multi-period, often market-wide metric focused on business cycle fluctuations.

FAQs

Why do companies report adjusted earnings?

Companies often report adjusted earnings to provide investors with a clearer picture of their core operational Profitability, excluding items they consider non-recurring or non-cash. This is intended to help stakeholders assess the underlying performance of the business.

Are adjusted earnings always reliable?

No. While adjusted earnings can offer useful insights, their reliability depends heavily on the nature of the adjustments made. Since companies have discretion over these adjustments, investors must carefully review the reconciliation between GAAP and non-GAAP figures in a company's Financial Reporting to understand what has been excluded or included.

How does the Adjusted Current P/E Ratio differ from the GAAP P/E Ratio?

The GAAP P/E Ratio uses a company's reported Earnings Per Share directly from its [Income Statement], which adheres strictly to Generally Accepted Accounting Principles. The Adjusted Current P/E Ratio, however, modifies this EPS figure by removing or adding back specific items that management deems extraordinary, providing a potentially "cleaner" view of ongoing operations.

Can the Adjusted Current P/E Ratio be negative?

Yes, if a company's adjusted earnings per share are negative, the Adjusted Current P/E Ratio will be negative. This typically indicates that the company is experiencing a loss on an adjusted basis, making valuation more complex.

When should an investor use the Adjusted Current P/E Ratio?

An investor should consider using the Adjusted Current P/E Ratio when a company's reported GAAP earnings are significantly impacted by one-time events, such as large asset sales, significant write-downs, or major litigation settlements. It helps to normalize the earnings and facilitates a more meaningful comparison of the company's valuation against its peers or its historical performance.