Adjusted economic earnings: Meaning, Criticisms & Real-World Uses

What Is Adjusted Economic Earnings?

Adjusted economic earnings represent a company's true underlying profitability, departing from traditional accounting measures to provide a more accurate picture of value creation. This metric falls under the broader category of Financial Analysis and Corporate Finance. Unlike statutory Accounting Earnings reported under Generally Accepted Accounting Principles (GAAP), adjusted economic earnings aim to capture all economic costs and benefits, including the cost of capital, thereby reflecting the genuine wealth generated or destroyed by a business. By making various adjustments to reported financial statements, analysts seek to neutralize the impact of accounting conventions that might obscure a company's operational performance and long-term value.

History and Origin

The concept of economic profit, which forms the foundation of adjusted economic earnings, dates back to classical economists like Alfred Marshall, who emphasized accounting for the "true profits" after deducting the cost of capital. Modern financial thought further developed this idea to address limitations of traditional accounting. A significant development in popularizing the concept of economic earnings in a corporate context was the introduction of Economic Value Added (EVA). Joel Stern and G. Bennett Stewart III, through their consulting firm Stern Stewart & Co., formally launched EVA in 1982, positioning it as a measure that better reflects a company's true economic profit and its direct link to Shareholder Wealth creation. Stern Stewart advocated for a series of adjustments to GAAP accounting to arrive at a more realistic measure of surplus value and capital⁹. This approach aimed to align management incentives with value creation rather than just reported earnings.

Key Takeaways

Adjusted economic earnings seek to measure a company's actual profitability by considering both explicit and implicit costs, including the cost of capital.
They provide a more comprehensive view of a company's performance than traditional GAAP earnings, which can be influenced by accounting conventions and non-operating items.
This metric is crucial for Valuation Models and assessing a company's ability to create long-term value for its owners.
Calculating adjusted economic earnings often involves numerous adjustments to figures found in a company's Financial Statements, such as the Income Statement and Balance Sheet.

Formula and Calculation

While there isn't one universal formula for "adjusted economic earnings" as the specific adjustments can vary, the most common conceptual framework is embodied by Economic Value Added (EVA). EVA is a widely recognized form of economic profit that aims to quantify the value a company creates above its Cost of Capital.

The general formula for Economic Value Added (EVA) is:

\text{EVA} = \text{NOPAT} - (\text{Capital Invested} \times \text{WACC})

Where:

(\text{NOPAT}) (Net Operating Profit After Taxes) is the company's operating income after tax, but before financing costs. It represents the profit a company would make from its operations if it had no debt.
(\text{Capital Invested}) refers to the total capital employed by the business, including both debt and equity. This often requires significant adjustments to balance sheet figures to reflect true economic capital.
(\text{WACC}) (Weighted Average Cost of Capital) is the average rate of return a company expects to pay to all its capital providers (both debt and equity holders). It serves as the hurdle rate for investments.

The adjustments to calculate NOPAT and Capital Invested for economic earnings purposes typically include:

Capitalizing operating leases.
Expensing goodwill and R&D.
Adjusting for deferred taxes.
Removing non-recurring or unusual items.

These adjustments aim to convert accounting numbers into a truer reflection of the capital at risk and the cash profits generated from that capital. Another way to express it is through Return on Invested Capital (ROIC):

\text{EVA} = (\text{ROIC} - \text{WACC}) \times \text{Capital Invested}

This formula highlights that value is created only when the return generated on invested capital exceeds the cost of that capital.

Interpreting the Adjusted Economic Earnings

Interpreting adjusted economic earnings involves assessing whether a company is generating value that exceeds the cost of the capital it employs. A positive adjusted economic earnings figure indicates that the company is creating wealth for its investors. This means the business's operations are profitable enough not only to cover its explicit operating expenses and taxes but also to provide a return to its capital providers (both debt and equity) that is greater than their minimum required rate of return, or Opportunity Cost. Conversely, a negative adjusted economic earnings figure suggests that the company is destroying value, as its economic profits do not cover its total cost of capital.

Analysts use adjusted economic earnings to evaluate the efficiency of a company's capital allocation and its sustainable competitive advantage. It helps in understanding if growth is truly profitable or if it's merely increasing revenue without generating sufficient returns on the Capital Investment required. Over time, consistent positive adjusted economic earnings are a strong indicator of a healthy, value-creating business.

Hypothetical Example

Consider "AlphaTech Inc.," a rapidly growing software company. For the past fiscal year, AlphaTech reported a GAAP net income of $20 million. However, an analyst wants to calculate its adjusted economic earnings to understand its true profitability.

Assumptions:

AlphaTech's reported Net Operating Profit After Taxes (NOPAT) (after some initial GAAP adjustments) is $25 million.
The company has $150 million in total Capital Investment. This includes adjustments for capitalized R&D and operating leases that GAAP might treat differently.
AlphaTech's Weighted Average Cost of Capital (WACC) is 12%.

Calculation:

Calculate the Capital Charge:
Capital Charge = Capital Invested × WACC
Capital Charge = $150,000,000 × 0.12 = $18,000,000
Calculate Adjusted Economic Earnings (EVA):
Adjusted Economic Earnings = NOPAT - Capital Charge
Adjusted Economic Earnings = $25,000,000 - $18,000,000 = $7,000,000

In this hypothetical example, AlphaTech Inc. generated $7 million in adjusted economic earnings. This positive figure indicates that AlphaTech's operations not only covered all explicit expenses and taxes but also provided a return of $7 million above the cost of the capital employed. This suggests that AlphaTech is creating wealth for its shareholders.

Practical Applications

Adjusted economic earnings are highly relevant in several practical financial applications, particularly in the realm of Valuation Models and performance measurement.

Corporate Valuation: Analysts often use adjusted economic earnings as a core input for valuing companies, especially when employing models like the Discounted Cash Flow (DCF) method or residual income models. Adjustments to reported earnings help analysts understand the "real" earnings capacity of a company, which is critical for forecasting future value. ⁸This provides a more robust basis for determining a company's Enterprise Value.
Performance Measurement: Companies may adopt adjusted economic earnings (like EVA) as an internal performance metric to align management incentives with value creation. By tying compensation to economic earnings, firms encourage managers to make decisions that truly enhance Shareholder Wealth, rather than just boosting reported accounting profits.
Capital Allocation Decisions: Understanding adjusted economic earnings helps companies make more informed decisions about allocating capital to new projects and investments. Projects are only considered value-accretive if their expected returns exceed the cost of the capital they consume, leading to positive adjusted economic earnings.
Mergers and Acquisitions (M&A): During M&A due diligence, buyers frequently adjust target companies' historical earnings to assess their true normalized profitability and earning power, removing non-recurring items or discretionary expenses to arrive at a more accurate valuation for the acquisition.
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Limitations and Criticisms

While adjusted economic earnings offer a more insightful view of a company's true profitability, they are not without limitations and criticisms. One significant challenge lies in the subjectivity and complexity of making the necessary adjustments. Unlike the standardized rules of Generally Accepted Accounting Principles (GAAP), there is no single, universally agreed-upon set of adjustments for calculating economic earnings. This can lead to inconsistencies and make comparisons between companies difficult unless the specific adjustments made are fully disclosed and understood.

Furthermore, the process of calculating adjusted economic earnings can be data-intensive and time-consuming, requiring detailed analysis beyond publicly available Financial Statements. Critics also point out that while the concept aims to provide a "truer" picture, the selection of adjustments can still be influenced by management's discretion, potentially leading to figures that are more favorable to the company. The Securities and Exchange Commission (SEC) periodically scrutinizes the use of non-GAAP financial measures, including adjusted earnings, to ensure they are not used in a misleading way and require companies to reconcile them to their GAAP counterparts to maintain transparency and prevent investor confusion. ³, ⁴, ⁵, ⁶Moreover, determining the appropriate Cost of Capital for a business can itself be complex, requiring estimations that can significantly impact the final adjusted economic earnings figure.

Adjusted Economic Earnings vs. GAAP Earnings

The fundamental distinction between adjusted economic earnings and GAAP Earnings lies in their purpose and underlying principles. GAAP earnings, such as net income reported on the income statement, adhere to a strict set of standardized accounting rules. These rules prioritize comparability, consistency, and verifiability, ensuring that financial information is presented uniformly across companies for regulatory and public reporting purposes. However, GAAP can be influenced by accounting conventions that may not always reflect the economic reality of a business, such as the historical cost principle, the treatment of intangible assets, or the expensing of certain investments like research and development (R&D).
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In contrast, adjusted economic earnings aim to go beyond these accounting conventions to capture a company's true economic profit. This involves making analytical adjustments to GAAP figures to account for items like the Opportunity Cost of capital, the economic depreciation of assets, and the capitalization of certain expenses that GAAP treats as period costs. While GAAP earnings tell investors what a company earned based on accounting rules, adjusted economic earnings attempt to reveal how much wealth a company truly created or destroyed by comparing its profits to the actual cost of the capital it employs. The confusion often arises because companies may present "adjusted" or "non-GAAP" earnings figures alongside their official GAAP results, but these adjustments may or may not align with the comprehensive economic adjustments made for a true adjusted economic earnings calculation.

FAQs

Q: Why are adjustments necessary for economic earnings?
A: Adjustments are necessary because traditional accounting standards (like GAAP) have conventions that might not fully reflect a company's true economic performance. For example, GAAP might expense R&D immediately, while economically, it's an investment that yields future benefits. Adjustments convert these accounting treatments into a more economically rational view, often including the explicit cost of using capital.

Q: Is "Economic Value Added" the same as "Adjusted Economic Earnings"?
A: Economic Value Added (EVA) is a specific, widely adopted framework for calculating economic profit, which is a form of adjusted economic earnings. While not every calculation labeled "adjusted economic earnings" will precisely follow the EVA methodology, EVA is arguably the most recognized and influential manifestation of the concept.

Q: How do adjusted economic earnings help investors?
A: Adjusted economic earnings help investors by providing a clearer picture of a company's sustainable profitability and its ability to generate returns above its funding costs. This is crucial for long-term investment decisions, as it helps identify companies that are genuinely creating value rather than just showing strong Earnings Per Share (EPS) due to accounting effects or non-recurring events.

Q: Are adjusted economic earnings audited?
A: Unlike GAAP financial statements, which are subject to external audits, adjusted economic earnings are typically calculated by analysts or internally by companies and are generally not subject to the same rigorous external audit requirements. Companies may present "non-GAAP" figures, which are often adjusted earnings, but these must be reconciled to the GAAP measures in public filings, as overseen by regulatory bodies.