Adjusted earnings yield

What Is Adjusted Earnings Yield?

Adjusted earnings yield is a financial metric used in investment analysis that measures a company's profitability relative to its stock price, but after certain modifications are made to its reported earnings per share. It falls under the broader category of valuation metrics, providing investors with a potentially more accurate representation of a company's ongoing operational performance by removing the impact of non-recurring items or other distorting factors. While standard earnings yield uses reported net income, adjusted earnings yield seeks to normalize these figures, offering a clearer view of a company's sustainable earning power. This adjustment aims to provide a truer reflection of the company's core business profitability, allowing for better comparability between companies and over different periods.

History and Origin

The concept of adjusting reported earnings, which underpins the adjusted earnings yield, has evolved alongside the increasing complexity of corporate financial reporting. Historically, financial statements were more straightforward, primarily adhering to Generally Accepted Accounting Principles (GAAP) in the U.S. or similar standards globally. However, as businesses grew more intricate with various one-off transactions, restructurings, and non-cash charges, companies began to present "pro forma" or "adjusted" results to highlight what they considered their core operational performance.

The formalization of financial reporting standards began to take shape in the U.S. after the stock market crash of 1929 and the Great Depression, leading to the creation of the Securities and Exchange Commission (SEC) in 1934 to regulate the securities industry and enforce standardized reporting¹². Over the decades, organizations like the Financial Accounting Standards Board (FASB) in the U.S. and the International Accounting Standards Board (IASB), which developed International Financial Reporting Standards (IFRS), have continuously developed and updated these principles¹¹,¹⁰. The practice of presenting adjusted earnings, however, often diverges from these standard accounting frameworks. This practice gained significant traction, particularly in the early 2000s, as companies sought to communicate their underlying profitability by excluding items deemed non-operational or unusual. The SEC has since provided guidance to regulate the use and disclosure of these "non-GAAP financial measures" to ensure transparency and prevent misleading presentations⁹.

Key Takeaways

• Adjusted earnings yield provides a valuation metric that attempts to normalize a company's profitability by excluding one-time or non-recurring financial events.
• It is calculated by dividing adjusted earnings per share by the stock's current market price.
• The adjustments aim to reflect a company's sustainable operational performance, allowing for better comparability.
• While useful for analysis, adjusted earnings yield relies on management's discretion in making adjustments, which can be subject to criticism.
• Investors should use adjusted earnings yield in conjunction with GAAP-compliant metrics and a thorough understanding of the underlying adjustments.

Formula and Calculation

The formula for adjusted earnings yield is derived from the standard earnings yield, with the crucial modification of using "adjusted earnings" instead of reported earnings.

The formula is expressed as:

Where:

• Adjusted Earnings Per Share (EPS): This is the company's earnings per share after certain operating expenses, non-recurring gains, or losses, and other unusual items have been added back or subtracted to reflect the core profitability of the business. These adjustments are typically disclosed in a company's financial reports, often in the notes or supplemental information that accompanies the main income statement.
• Current Market Price Per Share: This is the most recent trading price of the company's common stock on a stock exchange.

To calculate adjusted EPS, an analyst typically starts with the reported GAAP net income and makes specific additions or subtractions. Common adjustments might include removing restructuring charges, asset impairment write-downs, gains or losses from the sale of non-core assets, or litigation settlements. The goal is to arrive at an earnings figure that reflects the company's ongoing operational performance, free from one-off distortions.

Interpreting the Adjusted Earnings Yield

Interpreting the adjusted earnings yield involves understanding what the adjusted figure signifies about a company's fundamental value and its operational efficiency. A higher adjusted earnings yield generally suggests that an investor is getting more earnings for each dollar invested in the stock, which can indicate an undervalued stock or a more profitable company relative to its share price. Conversely, a lower adjusted earnings yield might suggest an overvalued stock or lower profitability per share.

When evaluating the adjusted earnings yield, it is crucial to consider the context of the adjustments made. Analysts use adjusted earnings to gain insight into a company's "true" earning capacity by removing items that are not considered part of its normal operations⁸. For example, if a company reports a net loss due to a large, one-time restructuring charge, its adjusted earnings might show a profit, providing a different perspective on its underlying financial health⁷.

This metric is particularly useful when comparing companies within the same industry, as it can help normalize differences that arise from unusual accounting events. However, investors must scrutinize the adjustments made to ensure they are appropriate and not overly aggressive, as improper adjustments can mislead about actual financial performance. It should always be considered alongside other financial statements and financial ratios for a comprehensive picture.

Hypothetical Example

Consider a hypothetical company, "GreenTech Solutions Inc.," which reported the following for its most recent fiscal year:

• Reported Net Income: $5,000,000
• Common Shares Outstanding: 1,000,000
• Current Stock Price: $40.00 per share

During the year, GreenTech incurred a one-time litigation settlement expense of $1,000,000 and had a one-time gain from the sale of an old factory building of $500,000. These are considered non-recurring for the purpose of adjusted earnings analysis.

Step 1: Calculate Reported Earnings Per Share (EPS)
Reported EPS = Net Income / Common Shares Outstanding
Reported EPS = $5,000,000 / 1,000,000 = $5.00

Step 2: Calculate Adjusted Net Income
Adjusted Net Income = Reported Net Income + One-time Litigation Expense - One-time Gain on Asset Sale
Adjusted Net Income = $5,000,000 + $1,000,000 - $500,000 = $5,500,000

Step 3: Calculate Adjusted Earnings Per Share (EPS)
Adjusted EPS = Adjusted Net Income / Common Shares Outstanding
Adjusted EPS = $5,500,000 / 1,000,000 = $5.50

Step 4: Calculate Adjusted Earnings Yield
Adjusted Earnings Yield = Adjusted EPS / Current Stock Price
Adjusted Earnings Yield = $5.50 / $40.00 = 0.1375 or 13.75%

In this example, the adjusted earnings yield of 13.75% provides a slightly more optimistic view of GreenTech Solutions Inc.'s core earning power compared to the unadjusted earnings yield (calculated as $5.00 / $40.00 = 12.5%). This adjusted figure aims to show what the company would have earned without the unique, non-recurring events, which can be valuable for forecasting future performance.

Practical Applications

Adjusted earnings yield is a versatile metric with several practical applications across various financial disciplines.

1. Equity Valuation: Investors and analysts frequently use adjusted earnings yield as a key component in equity valuation models. By utilizing adjusted earnings, they can compare a company's earning power more consistently with its peers or against its own historical performance, especially when companies have significant capital expenditures or other unique financial events. This provides a clearer picture of the value an investor receives for each dollar invested.
2. Mergers and Acquisitions (M&A): In M&A transactions, buyers often conduct a "Quality of Earnings" (QoE) analysis, which heavily relies on making adjustments to a target company's historical earnings. This process aims to understand the sustainable, normalized earnings of the business, free from one-off gains or losses, to determine a fair purchase price⁶. Adjusted earnings yield can then be used as part of this broader due diligence to evaluate the acquisition target.
3. Performance Evaluation: Companies themselves may use adjusted earnings internally to assess the performance of different business segments or to set performance targets for management compensation. This allows them to focus on operational efficiency without the distortion of unusual or uncontrollable events. However, external stakeholders should be aware that internal adjustments for performance evaluation can sometimes be biased⁵.
4. Credit Analysis: Lenders and credit rating agencies may also look at adjusted earnings to gauge a company's ability to generate consistent cash flow for debt repayment. By stripping out volatile, non-recurring items, they can better assess the underlying financial health and stability of a borrower.
5. Regulatory Compliance and Disclosure: While adjusted earnings (or non-GAAP measures) offer flexibility, their use is subject to scrutiny by regulatory bodies like the SEC. Companies are required to reconcile these non-GAAP measures to their most comparable GAAP measures and explain their utility, ensuring transparency for investors⁴.

Limitations and Criticisms

Despite its utility, adjusted earnings yield has several limitations and faces significant criticism, primarily due to the subjective nature of the adjustments themselves.

One major criticism is the potential for management to manipulate adjusted earnings to present a more favorable financial picture. Companies might exclude legitimate, recurring operating expenses or consistently label certain costs as "one-time" or "non-recurring" to inflate their adjusted profitability³. This can lead to an adjusted earnings figure that significantly overstates actual performance, potentially misleading investors. For example, some companies have excluded stock-based compensation from adjusted earnings, despite it being a real expense².

Another limitation stems from the lack of standardization in how adjusted earnings are calculated. Unlike GAAP or IFRS, there are no universal rules governing which items can or cannot be adjusted. This variability makes it challenging to compare the adjusted earnings yield of different companies, as each might apply a different set of adjustments. An adjusted earnings yield from one company might not be directly comparable to that of another, even within the same industry.

Furthermore, relying heavily on adjusted earnings yield without considering GAAP-compliant metrics can obscure a company's true financial health. While the intent of adjustments is often to show core operations, some "non-recurring" items, such as restructuring charges, might occur frequently enough for certain businesses to be considered quasi-recurring. Omitting them could paint an overly optimistic picture of a company's financial resilience. Academic studies and financial commentators have raised concerns about the growing gap between reported GAAP earnings and adjusted earnings, suggesting that the latter can be susceptible to bias or misinterpretation¹. Investors are advised to look at all aspects of a company's financial statements, including the balance sheet and cash flow statement, and to carefully scrutinize the nature of any adjustments made.

Adjusted Earnings Yield vs. Earnings Yield

Adjusted earnings yield and standard earnings yield are both valuation metrics that relate a company's profitability to its stock price, but they differ fundamentally in the definition of "earnings" used in their calculation.

Earnings Yield is the inverse of the price-to-earnings ratio (P/E ratio) and is calculated by dividing a company's reported earnings per share (EPS) by its current market price per share. The EPS used in this calculation is typically the GAAP (Generally Accepted Accounting Principles) or IFRS-compliant net income divided by the number of outstanding shares. This figure represents the company's "official" profitability as determined by standardized accounting rules, reflecting all revenues, expenses, gains, and losses, including those that may be one-time or non-recurring.

Adjusted Earnings Yield, as discussed, uses an "adjusted earnings per share" figure. This adjusted EPS is derived by taking the GAAP or IFRS earnings and adding back or subtracting specific items that management or analysts deem to be non-operational, non-recurring, or otherwise distorting to the company's core business performance. Examples include restructuring costs, asset impairments, gains/losses from asset sales, or legal settlements. The primary aim of adjusted earnings yield is to provide a "normalized" view of profitability that highlights the recurring earning power of the business.

The key distinction lies in the subjectivity of adjustments. While standard earnings yield relies on universally accepted accounting principles, adjusted earnings yield allows for discretion in what is included or excluded. This flexibility can be a strength, providing a clearer operational view, but it can also be a weakness if adjustments are used to artificially inflate perceived performance. Investors should always understand the specific adjustments made when comparing the adjusted earnings yield to the standard earnings yield or to similar metrics of other companies.

FAQs

Why do companies report adjusted earnings?

Companies often report adjusted earnings to provide a clearer view of their core business operations. They may exclude non-recurring items, such as one-time merger costs, significant asset sales, or litigation expenses, believing these do not reflect their ongoing profitability. The goal is to help investors understand the company's sustainable earning power.

Is adjusted earnings yield more reliable than standard earnings yield?

Adjusted earnings yield can be more reliable for analyzing a company's ongoing operational performance because it attempts to remove distortions from unusual events. However, its reliability depends heavily on the transparency and appropriateness of the adjustments made. Investors should always scrutinize the adjustments and compare them to the standard earnings yield to get a complete picture.

What kinds of adjustments are typically made to earnings?

Common adjustments include adding back non-cash expenses like stock-based compensation or depreciation, removing one-time restructuring costs, gains or losses from the sale of assets, legal settlements, and impairment charges. The specific adjustments vary by company and industry.

Can adjusted earnings yield be used for all types of companies?

Adjusted earnings yield can be applied to most companies, especially those with publicly traded stock. It is particularly useful for companies that frequently undergo significant one-time events, such as those in rapidly evolving industries or those undergoing frequent mergers and acquisitions, where unadjusted earnings might be highly volatile.

How does adjusted earnings yield relate to the Price-to-Earnings (P/E) ratio?

Adjusted earnings yield is the inverse of the adjusted price-to-earnings ratio. If you calculate the P/E ratio using adjusted earnings per share, then taking the reciprocal of that P/E ratio will give you the adjusted earnings yield. Both metrics serve as valuation tools, but the yield format can sometimes be easier to compare to interest rates or bond yields.