Adjusted deferred p e ratio

What Is Adjusted Deferred P/E Ratio?

The Adjusted Deferred P/E Ratio is a valuation metric that modifies the conventional Price-to-Earnings (P/E) Ratio by accounting for the non-cash impact of deferred taxes on a company's Earnings Per Share (EPS). This adjustment aims to present a clearer picture of a company's operational profitability, removing distortions caused by Temporary Differences between accounting profit and Taxable Income. As such, it falls under the broader field of Financial Analysis, offering a more refined perspective for investors and analysts.

Deferred taxes arise because the timing of revenue and expense recognition for financial reporting (under Accounting Standards like GAAP or IFRS) often differs from the timing for tax purposes. These differences create Deferred Tax Liabilities or Deferred Tax Assets on a company's Balance Sheet, which impact the reported Net Income but do not represent actual cash tax payments or refunds in the current period. The Adjusted Deferred P/E Ratio seeks to neutralize these non-cash effects to provide a more representative earnings figure for valuation.

History and Origin

While there is no single, universally recognized "inventor" or specific historical moment for the Adjusted Deferred P/E Ratio, its conceptual origin stems from the ongoing efforts of financial analysts and academics to refine Valuation Multiples. The traditional Price-to-Earnings (P/E) Ratio, while widely used, can be influenced by various accounting treatments and non-recurring items. Analysts often adjust reported earnings to normalize them and gain a truer understanding of a company's sustainable earning power.

The need for such adjustments became more pronounced with the increasing complexity of tax laws and accounting standards governing deferred taxes. As early as the 1990s, the Financial Accounting Standards Board (FASB) issued guidance such as Statement of Financial Accounting Standards (SFAS) 109, "Accounting for Income Taxes," which laid out principles for recognizing and measuring deferred tax assets and liabilities. The FASB later simplified the classification of deferred taxes, requiring all deferred tax assets and liabilities to be classified as noncurrent as of 2016 for public companies⁹. These accounting nuances spurred analysts to consider how deferred tax provisions, which are often non-cash, might distort reported earnings and, consequently, valuation ratios. Therefore, the Adjusted Deferred P/E Ratio emerged as an analytical tool to address these specific distortions.

Key Takeaways

• The Adjusted Deferred P/E Ratio refines the standard P/E by removing the non-cash impact of deferred taxes from earnings.
• It aims to provide a more accurate reflection of a company's core, cash-generating profitability.
• This adjustment helps analysts compare companies more consistently by normalizing earnings across different tax and accounting treatments.
• The ratio highlights how temporary differences between accounting and tax rules can influence reported earnings.
• Interpreting the Adjusted Deferred P/E Ratio requires understanding the nature of a company's deferred tax positions.

Formula and Calculation

The Adjusted Deferred P/E Ratio is calculated by dividing a company's current share price by its adjusted earnings per share. The key is in deriving the "adjusted earnings per share," which conceptually involves reversing the non-cash impact of deferred taxes on the reported Net Income.

The basic formula for the Price-to-Earnings Ratio is:

For the Adjusted Deferred P/E Ratio, the modification occurs in the denominator:

Where:

• Market Price per Share: The current market price of one share of the company's stock.
• Adjusted Earnings Per Share: This is the reported Earnings Per Share (EPS) modified to exclude the non-cash portion of income tax expense (or benefit) related to deferred taxes.

To calculate Adjusted Earnings Per Share, one approach is:

• Reported EPS: The company's earnings per share as reported on its Income Statement.
• Net Deferred Tax Expense (Benefit): This represents the non-cash change in Deferred Tax Liabilities and Deferred Tax Assets during the period. A deferred tax expense reduces reported net income but is non-cash, so it would be added back. A deferred tax benefit increases reported net income but is non-cash, so it would be subtracted. This information is typically found in the income tax footnote to the Financial Statements.

Interpreting the Adjusted Deferred P/E Ratio

Interpreting the Adjusted Deferred P/E Ratio involves understanding how the removal of non-cash deferred tax impacts alters the traditional Price-to-Earnings (P/E) Ratio and what this implies about a company's valuation. A key purpose of this adjustment is to provide a cleaner measure of a company's underlying earnings power, which can be obscured by the complex interplay of financial reporting and tax regulations.

If a company has significant non-cash Deferred Tax Liabilities that have reduced its reported Net Income (i.e., a deferred tax expense), adding this back will increase the adjusted earnings per share, thereby lowering the Adjusted Deferred P/E Ratio. Conversely, if a company has significant non-cash Deferred Tax Assets that have boosted its reported net income (i.e., a deferred tax benefit), subtracting this out will decrease the adjusted earnings per share, leading to a higher Adjusted Deferred P/E Ratio.

A lower Adjusted Deferred P/E Ratio might suggest that a company is more attractively valued when its earnings are viewed from a perspective that excludes temporary tax accounting effects. This adjusted ratio can be particularly useful when comparing companies within the same industry that may have different accounting methods for depreciation or other items that lead to varying deferred tax positions. By normalizing for these tax-related timing differences, analysts can gain a more consistent basis for comparing the operational efficiency and profitability that drives long-term value.

Hypothetical Example

Consider two hypothetical companies, TechCo and ServiceCo, both operating in the same industry with a current share price of $100.

TechCo's Reported Data:

• Reported Earnings Per Share (EPS): $5.00
• Net Deferred Tax Expense (non-cash): $0.50 per share (meaning reported earnings were reduced by this non-cash item)

ServiceCo's Reported Data:

• Reported Earnings Per Share (EPS): $5.20
• Net Deferred Tax Benefit (non-cash): $0.20 per share (meaning reported earnings were boosted by this non-cash item)

Calculating Reported P/E Ratios:

• TechCo P/E: $100 / $5.00 = 20x
• ServiceCo P/E: $100 / $5.20 = 19.23x

Based solely on the reported P/E, ServiceCo appears slightly cheaper. Now, let's calculate the Adjusted Deferred P/E Ratio.

Calculating Adjusted EPS:

• TechCo Adjusted EPS: $5.00 + $0.50 = $5.50 (adding back the non-cash deferred tax expense)
• ServiceCo Adjusted EPS: $5.20 - $0.20 = $5.00 (subtracting the non-cash deferred tax benefit)

Calculating Adjusted Deferred P/E Ratios:

• TechCo Adjusted Deferred P/E: $100 / $5.50 = 18.18x
• ServiceCo Adjusted Deferred P/E: $100 / $5.00 = 20.00x

In this hypothetical example, after adjusting for the non-cash impact of deferred taxes, TechCo's Adjusted Deferred P/E of 18.18x is lower than ServiceCo's 20.00x. This indicates that, when considering their core, operational profitability stripped of temporary tax accounting effects, TechCo might be a more attractive investment than initially suggested by the unadjusted Financial Ratios.

Practical Applications

The Adjusted Deferred P/E Ratio finds practical application primarily in Fundamental Analysis and equity research, where analysts seek to derive a more accurate picture of a company's earnings power for valuation.

1. Enhanced Valuation: By adjusting for non-cash deferred tax impacts, investors can arrive at a more "normalized" earnings figure, which can lead to more robust Valuation Multiples. This is particularly useful for companies with significant Temporary Differences due to accelerated depreciation, different revenue recognition methods for tax versus financial reporting, or tax loss carryforwards. Such adjustments can prevent misinterpretation of a company's underlying financial health⁸,⁷.
2. Comparative Analysis: The Adjusted Deferred P/E Ratio allows for more equitable comparisons between companies in the same industry, especially if they employ different accounting policies or face varying tax treatments that result in disparate deferred tax positions. For example, a company with large capital expenditures might have significant deferred tax liabilities due to accelerated depreciation for tax purposes, artificially lowering its reported P/E. Adjusting for this provides a clearer view relative to competitors⁶. Companies like Apple Inc., with extensive international operations and complex tax structures, regularly report substantial deferred tax assets and liabilities in their annual filings with the U.S. Securities and Exchange Commission (SEC)⁵.
3. Quality of Earnings Assessment: This adjusted ratio provides insights into the "quality of earnings." Earnings that are heavily influenced by non-cash deferred tax benefits might be considered less sustainable than earnings derived from core operations and actual cash tax payments. Conversely, a company consistently incurring non-cash deferred tax expenses might be seen as having higher quality earnings when adjusted.
4. Forecasting: A deeper understanding of the impact of deferred taxes on earnings can improve the accuracy of future earnings forecasts. Analysts can better project a company's sustainable earnings by disentangling the cash and non-cash components of its tax expense⁴.

Limitations and Criticisms

While the Adjusted Deferred P/E Ratio offers a more refined view of a company's earnings, it is not without limitations and criticisms. Its primary drawback stems from its analytical nature rather than being a standardized or universally adopted Financial Ratio.

1. Lack of Standardization: Unlike the traditional Price-to-Earnings (P/E) Ratio, there is no single, agreed-upon method for calculating the "Adjusted Deferred P/E Ratio." Different analysts might make different assumptions or apply various methodologies for adjusting earnings, leading to inconsistent results. This lack of standardization can make it difficult for investors to compare analyses from different sources.
2. Complexity of Deferred Taxes: Understanding and accurately calculating deferred tax impacts requires a deep knowledge of Accounting Standards, tax laws, and a company's specific Financial Statements and footnotes. The process can be complex, involving an analysis of various Temporary Differences and the impact of Valuation Allowance³. Misinterpreting these figures can lead to incorrect adjustments.
3. Relevance of Non-Cash Items: Critics might argue that while deferred taxes are non-cash in the current period, they represent real future tax obligations or benefits. Ignoring them entirely in a valuation metric might overlook a significant aspect of a company's future cash flows and overall financial position. The impact of deferred taxes on company valuations is a recognized area of financial study, with academic research exploring their relevance²,¹.
4. Potential for Manipulation: Even with adjustments, the underlying reported earnings can sometimes be influenced by management's accounting choices, as noted in discussions about the traditional P/E ratio. While the Adjusted Deferred P/E Ratio aims to correct for deferred tax effects, it does not inherently account for other potential earnings management practices.

Adjusted Deferred P/E Ratio vs. Price-to-Earnings (P/E) Ratio

The Adjusted Deferred P/E Ratio and the Price-to-Earnings (P/E) Ratio are both Valuation Multiples used in Financial Analysis, but they differ significantly in their approach to a company's earnings.

Confusion often arises because both ratios use a company's share price and earnings. However, the Adjusted Deferred P/E Ratio attempts to refine the "earnings" component to address specific accounting complexities related to deferred taxes, which the basic P/E ratio does not explicitly consider. This distinction is crucial for investors who want to look beyond headline figures and assess the sustainable, operational profitability of a business.

FAQs

What are deferred taxes?

Deferred Tax Liabilities and Deferred Tax Assets arise from Temporary Differences between how revenue and expenses are recognized for financial reporting (accounting books) and for tax purposes. For instance, a company might recognize an expense on its income statement earlier than it can deduct it for tax, leading to a deferred tax asset, or vice versa for a deferred tax liability. These are non-cash items in the current period but represent future tax payments or deductions.

Why is the P/E ratio adjusted for deferred taxes?

The Price-to-Earnings (P/E) Ratio is adjusted for deferred taxes to remove the influence of non-cash deferred tax expenses or benefits on a company's reported Earnings Per Share (EPS). This adjustment aims to provide a clearer, more accurate view of a company's core operational profitability that is not distorted by accounting timing differences related to taxes.

Is the Adjusted Deferred P/E Ratio a standard financial metric?

No, the Adjusted Deferred P/E Ratio is generally not a standard, universally recognized, or officially mandated Financial Ratio like the traditional P/E ratio. It is primarily an analytical tool used by financial professionals to refine their valuation models and gain deeper insights into a company's earnings quality.

How do deferred taxes affect earnings?

Deferred taxes affect reported earnings because the income tax expense (or benefit) shown on the Income Statement includes both current taxes payable and the non-cash change in deferred tax assets and liabilities. This non-cash component can either increase or decrease the reported Net Income, depending on whether there's a deferred tax expense (which reduces net income) or a deferred tax benefit (which increases net income).