Adjusted earnings surprise

What Is Adjusted Earnings Surprise?

Adjusted earnings surprise is a financial metric in financial reporting that measures the difference between a company's reported adjusted earnings per share (EPS) and the consensus analyst estimates for that same period. Unlike a standard earnings surprise which typically uses figures calculated according to Generally Accepted Accounting Principles (GAAP), the adjusted earnings surprise incorporates non-GAAP financial measures. This adjusted EPS figure is often presented by management to provide what they consider a clearer picture of the company's operational performance by excluding certain non-recurring or non-cash items.

History and Origin

The concept of "adjusted earnings" gained prominence as companies sought to present their financial performance in a light they believed better reflected their core operations, often excluding volatile or non-cash charges. This trend led to an increase in the use of non-GAAP financial measures in corporate communications, particularly in earnings releases. The proliferation of these measures, while intended to provide additional insights, also raised concerns among regulators and investors regarding comparability and potential for manipulation.

In response to these concerns, the U.S. Securities and Exchange Commission (SEC) has issued guidance over the years on the use and presentation of non-GAAP financial measures, emphasizing that they should not be misleading and must be reconciled to the most directly comparable GAAP measures with equal or greater prominence.⁵ Financial professional organizations, such as the CFA Institute, have also extensively researched and highlighted investor uses, expectations, and concerns regarding non-GAAP measures, including adjusted earnings.⁴ The practice of reporting adjusted earnings and the subsequent calculation of adjusted earnings surprise thus evolved out of a desire for greater flexibility in communicating performance, balanced by regulatory oversight and investor scrutiny.

Key Takeaways

• Adjusted earnings surprise quantifies the difference between a company's reported adjusted earnings per share and Wall Street's consensus forecasts.
• It utilizes non-GAAP financial measures, which are often preferred by management to highlight core operational performance.
• A positive adjusted earnings surprise typically signals that a company performed better than analysts expected, potentially leading to a positive reaction in its share price.
• Conversely, a negative adjusted earnings surprise indicates underperformance relative to expectations.
• Investors and analysts often scrutinize the adjustments made to GAAP figures to ensure they provide a true and fair view of the company's underlying profitability.

Formula and Calculation

The formula for adjusted earnings surprise is straightforward:

[
\text{Adjusted Earnings Surprise} = \text{Reported Adjusted EPS} - \text{Analyst Consensus EPS Estimate}
]

Where:

• Reported Adjusted EPS represents the earnings per share figure reported by the company, after making specific non-GAAP adjustments.
• Analyst Consensus EPS Estimate is the average earnings per share forecast provided by financial analysts covering the company.

For example, if a company reports an adjusted net income that leads to an adjusted EPS of $1.50, and the analyst consensus estimate was $1.45, the adjusted earnings surprise would be:

($1.50 - $1.45 = $0.05)

A positive value indicates that the company exceeded expectations, while a negative value signifies a miss.

Interpreting the Adjusted Earnings Surprise

Interpreting an adjusted earnings surprise involves more than just noting whether the number is positive or negative. It requires understanding the qualitative context behind the adjustments and the quantitative impact on the company's financial standing. A positive adjusted earnings surprise can indicate strong operational execution, efficient cost management, or better-than-anticipated revenue generation. Conversely, a negative surprise might point to operational challenges, unforeseen expenses, or weaker demand.

Crucially, market participants often react strongly to earnings surprises, as they can significantly shift market expectations about a company's future performance. However, the nature of the "adjustments" in adjusted earnings surprise is key. Investors pay close attention to what items are excluded or included to arrive at the adjusted figure. Recurring operational expenses that are frequently excluded might raise flags, as they suggest the adjusted earnings may not fully reflect the company's true economic performance.³ Transparent disclosure of these adjustments is vital for credible interpretation.

Hypothetical Example

Consider "Tech Innovations Inc." (TII), a publicly traded software company. For the second quarter, analysts had a consensus EPS estimate of $0.75 per share. TII's management, however, chose to report an adjusted EPS, excluding a one-time charge of $5 million related to the impairment of an old software patent and $2 million in restructuring costs associated with a recent acquisition.

Here's how TII arrived at its adjusted earnings:

• GAAP Net Income: $45 million

• Shares Outstanding: 100 million

• GAAP EPS: $0.45 ($45 million / 100 million shares)

• Adjustments:

  • Add back patent impairment: $5 million
  • Add back restructuring costs: $2 million

• Adjusted Net Income: $45 million + $5 million + $2 million = $52 million

• Adjusted EPS: $0.52 ($52 million / 100 million shares)

In this scenario, TII's reported adjusted EPS is $0.52.

Now, calculate the adjusted earnings surprise:

(\text{Adjusted Earnings Surprise} = \text{Reported Adjusted EPS} - \text{Analyst Consensus EPS Estimate})
(\text{Adjusted Earnings Surprise} = $0.52 - $0.75 = -$0.23)

Despite the adjustments, Tech Innovations Inc. experienced a negative adjusted earnings surprise of -$0.23, meaning even after considering the one-time charges it chose to exclude, the company still fell short of analyst expectations. This might lead investors to re-evaluate their outlook on TII based on its financial statements and future prospects.

Practical Applications

Adjusted earnings surprise is a widely used metric in the financial world, particularly during the quarterly earnings season. Portfolio managers, individual investors, and financial analysts closely monitor this metric to gauge a company's performance against Wall Street's expectations.

• Investment Decisions: A positive adjusted earnings surprise can trigger positive investor sentiment, potentially leading to an increase in demand for a company's stock. Conversely, a negative surprise may prompt sell-offs. For example, during earnings season, companies that beat analyst estimates on adjusted earnings can see their stock prices rise, while those that miss can experience declines.²
• Performance Evaluation: Analysts use the adjusted earnings surprise to refine their financial models and update their recommendations. It helps them assess how well a company is managing its core business operations, separate from non-recurring or extraordinary events.
• Investor Relations: Companies often highlight their adjusted earnings figures and the associated surprise in their communications with investors, aiming to convey a consistent message about their underlying profitability and strategic direction.
• Capital Markets Analysis: Broadly, the aggregate adjusted earnings surprise across many companies can provide insights into the overall health and momentum of specific sectors or the broader economy.

Limitations and Criticisms

While adjusted earnings surprise aims to provide a clearer view of operational performance, it comes with several limitations and criticisms. The primary concern revolves around the discretionary nature of the adjustments. Unlike GAAP earnings, which follow a strict set of accounting rules, adjusted earnings are non-GAAP, meaning companies have significant leeway in deciding what items to exclude or include.

• Lack of Comparability: The flexibility in making adjustments can lead to a lack of comparability between different companies, or even for the same company across different reporting periods. Companies might exclude "non-recurring" items that, upon closer inspection, occur with some regularity, thereby presenting a perpetually rosier picture of profitability.
• Potential for Manipulation: Critics argue that management may use these adjustments to "manage" earnings, presenting figures that consistently meet or beat analyst estimates, irrespective of underlying economic reality.¹ This can obscure the true financial health of a company and its ongoing expenses. Strong corporate governance and vigilant audit committees are crucial in mitigating such risks.
• Exclusion of Real Costs: Some excluded items, while non-cash or non-recurring in a strict accounting sense, represent real economic costs to the business (e.g., stock-based compensation, restructuring charges, impairment losses). Excluding these can lead to an inflated perception of the company's true profitability and valuation.
• Regulatory Scrutiny: Regulators, like the SEC, continuously monitor the use of non-GAAP measures to prevent them from misleading investors. If adjustments are deemed inappropriate or given undue prominence, companies can face regulatory action.

Investors must exercise caution and conduct thorough financial analysis to understand the nature and consistency of these adjustments before making investment decisions based solely on adjusted earnings surprise.

Adjusted Earnings Surprise vs. Earnings Surprise

The core distinction between adjusted earnings surprise and earnings surprise lies in the type of earnings figure used as the baseline.

While the standard earnings surprise directly measures a company's performance against expectations based on standardized accounting rules, adjusted earnings surprise attempts to provide a more tailored view by accounting for specific items deemed non-representative of ongoing operations. The confusion often arises because both metrics measure a "surprise" against analyst expectations, but they do so from different starting points of reported earnings.

FAQs

What causes an adjusted earnings surprise?

An adjusted earnings surprise occurs when a company's reported adjusted earnings per share (EPS) differs from the consensus analyst estimate. This difference can be driven by a variety of factors, including stronger or weaker-than-expected revenue, better or worse cost control, or the impact of specific non-recurring items that management chooses to exclude or include in their adjusted figures.

Why do companies report adjusted earnings?

Companies often report adjusted earnings to provide what they consider a clearer picture of their underlying operational performance. They believe that certain items, such as one-time charges, stock-based compensation, or amortization of acquired intangibles, might distort the view of their core business profitability as presented under strict GAAP. The goal is to help investors and analysts focus on the recurring profitability of the business.

Is adjusted earnings surprise more important than GAAP earnings surprise?

The importance of adjusted earnings surprise versus GAAP earnings surprise is a subject of ongoing debate among investors and analysts. GAAP earnings provide a standardized, legally mandated view of a company's financial results, making them generally more comparable across different companies and industries. Adjusted earnings, while offering management's perspective on core performance, involve subjective adjustments. Many investors view both as important, using GAAP earnings for a comprehensive picture and adjusted earnings for insights into ongoing operational trends, but always with careful scrutiny of the adjustments made.

How do analysts use adjusted earnings surprise?

Analysts use adjusted earnings surprise to refine their financial models, update their price targets, and adjust their recommendations for a company's stock. A positive surprise might lead to an upward revision of future earnings forecasts, while a negative surprise could lead to a downward revision. They also use it to assess the accuracy of their own forecasting methods and to understand the key drivers of a company's performance.