Adjusted discounted earnings

What Is Adjusted Discounted Earnings?

Adjusted discounted earnings is a hypothetical financial metric that attempts to measure the present value of a company's future earnings, after making specific adjustments to those earnings. This concept falls under the broader category of Financial Reporting, as it involves modifying standard accounting figures to provide a different perspective on a company's underlying financial performance. While "adjusted earnings" typically refers to a non-GAAP measure, the "discounted" aspect introduces a valuation component, implying a method to determine the intrinsic valuation of an asset or company by forecasting its future earning power and bringing those future earnings back to a present value using a discount rate. The intention behind adjusted discounted earnings is to offer investors a clearer view of long-term profitability by removing the impact of one-time or non-recurring events and then valuing that normalized earning stream.

History and Origin

The foundational concepts behind adjusted discounted earnings derive from two distinct areas of financial analysis: the practice of using "adjusted earnings" and the methodology of "discounted earnings" or discounted cash flow valuation. The use of "adjusted earnings," also known as non-Generally Accepted Accounting Principles (non-GAAP) measures, gained significant prominence in corporate reporting, particularly in the early 2000s. Companies began presenting these alternative metrics to highlight what they considered their "core" operating performance, often excluding certain expenses like restructuring charges, impairment losses, or stock-based compensation.

However, the proliferation and varying methodologies of non-GAAP measures led to concerns about comparability and potential for misleading investors. In response, the U.S. Securities and Exchange Commission (SEC) adopted Regulation G and amended Item 10 of Regulation S-K in 2003, mandating that companies reconcile non-GAAP measures to their most directly comparable Generally Accepted Accounting Principles (GAAP) financial measures and explain why the non-GAAP measure is useful⁶. This regulatory push aimed to bring transparency and standardization to the use of adjusted figures.

Separately, the principle of discounting future earnings or cash flows to arrive at a present value has been a cornerstone of valuation theory for centuries, evolving from basic time value of money concepts. The combination, adjusted discounted earnings, represents an analytical approach that merges the flexibility of adjusted earnings with the rigor of discounted valuation methods to assess a company's intrinsic worth based on its normalized earning capacity.

Key Takeaways

• Adjusted discounted earnings combines non-GAAP earnings adjustments with a present value calculation.
• The primary goal is to normalize future earnings by excluding non-recurring or non-operational items.
• It is used to estimate the intrinsic value of a company based on its adjusted earning power over time.
• This metric requires significant assumptions regarding future earnings, growth rates, and the appropriate discount rate.
• Regulatory bodies like the SEC monitor the use and disclosure of non-GAAP adjustments.

Formula and Calculation

While there isn't one universally codified formula for "Adjusted Discounted Earnings," it typically involves a two-step process:

1. Adjusting Historical and Projecting Future Earnings: This step involves taking reported net income and making adjustments for non-recurring or non-operating items to arrive at a "normalized" or "adjusted" earnings figure. These adjusted earnings are then projected into the future.
2. Discounting Future Adjusted Earnings: The projected adjusted earnings for each future period are discounted back to the present using a chosen discount rate.

The general formula for a discounted value calculation, applied to adjusted earnings, can be expressed as:

Where:

• (\text{Adjusted Earnings}_t) = The projected earnings for period (t), after making specific adjustments.
• (r) = The discount rate, often representing the investor's required rate of return or the company's weighted average cost of capital.
• (t) = The specific future period (e.g., year 1, year 2, etc.).
• (n) = The number of discrete projection periods.
• (\text{Terminal Value}) = The value of all adjusted earnings beyond the discrete projection period (n), also discounted back to the present. The Terminal Value itself is often calculated using a perpetuity growth model or exit multiple.

Calculating the discount rate appropriately is crucial for the accuracy of adjusted discounted earnings.

Interpreting the Adjusted Discounted Earnings

Interpreting adjusted discounted earnings involves understanding that the resulting figure is an estimated intrinsic value derived from a specific set of assumptions about future performance and the cost of capital. A higher adjusted discounted earnings value suggests a greater underlying earning power and potential for shareholder value creation based on the normalization assumptions.

Users often compare this calculated value to the current market capitalization of a company to assess whether the stock is undervalued or overvalued. If the adjusted discounted earnings per share (derived by dividing the total adjusted discounted earnings by the number of outstanding shares) is significantly higher than the current earnings per share (EPS) or stock price, it might indicate an investment opportunity, assuming the adjustments and projections are sound. Conversely, a lower figure might suggest overvaluation. It's essential to scrutinize the adjustments made to the earnings and the rationale behind the chosen discount rate, as these inputs heavily influence the final output. The metric provides a forward-looking perspective, contrasting with historical measures found on a company's income statement.

Hypothetical Example

Consider a hypothetical technology company, InnovateCorp, that reported a net income of $100 million in the past year. However, this net income included a one-time gain of $20 million from selling a non-core asset and also incurred $15 million in significant restructuring costs for a major operational overhaul.

To calculate adjusted discounted earnings, an analyst might first normalize InnovateCorp's earnings:

• Reported Net Income: $100 million
• Less: One-time gain from asset sale: -$20 million
• Add: Restructuring costs (considered non-recurring for core operations): +$15 million
• Adjusted Earnings (Normalized): $95 million

Now, assume the analyst projects these adjusted earnings to grow by 5% annually for the next three years, and then maintain a terminal growth rate of 2% thereafter. The chosen discount rate is 10%.

Year 1 Adjusted Earnings: $95 million * (1 + 0.05) = $99.75 million
Year 2 Adjusted Earnings: $99.75 million * (1 + 0.05) = $104.74 million
Year 3 Adjusted Earnings: $104.74 million * (1 + 0.05) = $110.00 million

Discounted Values for Discrete Periods:

• Year 1: (\frac{$99.75 \text{ million}}{(1 + 0.10)^1} = $90.68 \text{ million})
• Year 2: (\frac{$104.74 \text{ million}}{(1 + 0.10)^2} = $86.56 \text{ million})
• Year 3: (\frac{$110.00 \text{ million}}{(1 + 0.10)^3} = $82.65 \text{ million})

Terminal Value Calculation (as of Year 3):
The adjusted earnings for Year 4 would be $110.00 million * (1 + 0.02) = $112.20 million.
Terminal Value at Year 3: (\frac{$112.20 \text{ million}}{(0.10 - 0.02)} = \frac{$112.20 \text{ million}}{0.08} = $1,402.50 \text{ million})

Discounted Terminal Value (back to Present):
(\frac{$1,402.50 \text{ million}}{(1 + 0.10)^3} = $1,053.48 \text{ million})

Total Adjusted Discounted Earnings:
$90.68 million + $86.56 million + $82.65 million + $1,053.48 million = $1,313.37 million

This hypothetical example illustrates how the cash flow from normalized earnings, when adjusted for non-recurring events, contributes to a company's overall present value.

Practical Applications

Adjusted discounted earnings, while not a standard GAAP metric, finds practical applications primarily in investor relations and advanced financial analysis.

• Valuation Models: Investment analysts and portfolio managers frequently use adjusted earnings within discounted earnings or discounted cash flow models to arrive at a target stock price. By adjusting earnings for items like one-off litigation settlements, asset sales, or significant restructuring costs, analysts aim to forecast a more stable and representative stream of future profitability for their valuation models.
• Performance Evaluation: Companies often present adjusted earnings metrics, such as adjusted EBITDA or adjusted net income, in their earnings releases to help stakeholders understand performance excluding volatile or non-operational items. This is particularly common when companies want to emphasize their underlying operational strength. The Financial Accounting Standards Board (FASB) actively seeks feedback on financial key performance indicators (KPIs), including adjusted metrics, recognizing their widespread use by companies in communicating results to investors⁵.
• Mergers and Acquisitions (M&A): In M&A deals, potential acquirers may adjust the target company's historical earnings to arrive at a "normalized" earnings base before projecting future earnings and discounting them. This helps in assessing the true earning power of the target, unburdened by past extraordinary events.
• Internal Management Reporting: Management teams may utilize adjusted earnings internally to gauge the performance of core business segments, separate from the noise of non-recurring events, which can inform strategic decisions related to resource allocation and operational efficiency. The widespread use of non-GAAP measures by companies to supplement their financial statements and deepen investors' understanding of performance or financial condition highlights their perceived utility⁴.

Limitations and Criticisms

Despite its analytical utility, adjusted discounted earnings faces several significant limitations and criticisms, primarily stemming from the subjective nature of the "adjustments" and the inherent challenges of forecasting.

• Subjectivity of Adjustments: The primary criticism is the lack of standardization in what constitutes an "adjustment." Companies have considerable discretion in deciding which items to exclude from their GAAP earnings to arrive at an adjusted figure. This can lead to inconsistencies between companies and even within the same company over different periods, making comparisons difficult. Critics argue that some adjustments may exclude legitimate, recurring operating expenses, thereby inflating the perceived revenue or profitability³. The SEC has expressed concerns about the potential for non-GAAP measures to be misleading if they exclude normal, recurring operating expenses necessary to operate a business².
• Potential for Manipulation: The flexibility in making adjustments can be exploited to present a more favorable financial picture than GAAP earnings might suggest, potentially misleading investors about a company's true profitability or expenses. Regulators continuously monitor this area, issuing guidance to ensure that non-GAAP disclosures are not unduly prominent or misleading¹.
• Forecasting Risk: Discounted earnings models, by their nature, rely heavily on future earnings projections, which are inherently uncertain. Any inaccuracies in forecasting growth rates, economic conditions, or industry trends can significantly impact the calculated adjusted discounted earnings value.
• Discount Rate Sensitivity: The chosen discount rate is a critical input, and even small changes can lead to large swings in the present value. Determining the appropriate discount rate can be subjective and is a common area of debate in valuation.
• Lack of Comparability: Since there is no GAAP standard for "adjusted discounted earnings," direct comparisons between different companies using this metric are challenging. Each company or analyst may have a unique set of adjustments, rendering an "apples-to-apples" comparison impossible.

Adjusted Discounted Earnings vs. Net Income

The distinction between adjusted discounted earnings and net income lies fundamentally in their purpose and how they are calculated.

While net income provides a standardized, historical view of profitability, adjusted discounted earnings attempts to offer a forward-looking, normalized perspective of a company's earning potential for valuation purposes.

FAQs

What does "adjusted" mean in financial terms?

In financial terms, "adjusted" refers to modifications made to a company's reported financial figures, typically those adhering to Generally Accepted Accounting Principles (GAAP), to exclude or include certain items. These adjustments usually aim to remove the impact of one-time events, non-recurring charges, or non-operating gains/losses, providing a picture of a company's "core" or ongoing financial performance.

Why do companies use adjusted earnings?

Companies use adjusted earnings to highlight what they believe is their underlying operational profitability, separate from unusual or non-recurring events. For instance, they might adjust for large restructuring costs, legal settlements, or gains from asset sales to present a clearer view of their regular business activities to investors and analysts.

Is adjusted discounted earnings a GAAP measure?

No, adjusted discounted earnings is not a GAAP measure. The "adjusted" component signifies that it deviates from GAAP by including company-specific modifications to reported earnings. The "discounted" aspect relates to valuation methodologies rather than accounting standards.

What is the primary benefit of using adjusted discounted earnings?

The primary benefit is its ability to provide an estimated intrinsic valuation of a company based on its normalized, ongoing earning power. By removing the "noise" of non-recurring items from historical earnings and projecting these adjusted figures, analysts can gain a more stable and representative basis for valuing a business.