Adjusted eps

What Is Adjusted EPS?

Adjusted earnings per share (Adjusted EPS) is a non-Generally Accepted Accounting Principles (non-GAAP) financial measure that modifies a company's reported earnings per share (EPS) by excluding certain income or expense items that management deems non-recurring, unusual, or non-operating. Within the realm of financial reporting and analysis, the purpose of Adjusted EPS is to provide investors with a clearer view of a company's core operational profitability by removing the impact of volatile or one-time events. While the traditional EPS calculation, based on net income from the income statement prepared under Generally Accepted Accounting Principles (GAAP), provides a standardized view, Adjusted EPS aims to present earnings that are considered more representative of ongoing business performance. This metric is categorized under financial reporting and analysis, specifically within the broader domain of non-GAAP financial measures.

History and Origin

The practice of presenting earnings figures that deviate from GAAP began to gain prominence in the mid-1990s, often referred to as "pro forma" earnings. Companies started to exclude various items, such as restructuring charges, merger-related expenses, and the amortization of intangible assets, from their reported earnings in an attempt to show what they considered "core" profitability. This trend increased significantly, particularly during the dot-com bubble era, leading to concerns from regulators and investors about the potential for misleading financial portrayals.

In response to these growing concerns, the U.S. Securities and Exchange Commission (SEC) introduced Regulation G and updated Item 10(e) of Regulation S-K in 2003. These regulations were designed to provide guidelines and requirements for companies disclosing non-GAAP financial measures. The SEC's aim was to ensure that if companies presented non-GAAP figures like Adjusted EPS, they must also present the most directly comparable GAAP measure with equal or greater prominence, along with a reconciliation between the two. The SEC continues to issue updated SEC guidance on non-GAAP financial measures to address evolving practices and maintain transparency.

Key Takeaways

• Adjusted EPS is a non-GAAP financial measure that modifies standard EPS by excluding certain items.
• Its aim is to reflect a company's ongoing operational profitability by removing one-time or non-recurring events.
• Common adjustments include acquisition costs, stock-based compensation, and certain asset impairments.
• Companies must provide a reconciliation between Adjusted EPS and its most comparable GAAP measure, such as diluted EPS.
• While Adjusted EPS can offer additional insights, it requires careful scrutiny due to the discretion involved in its calculation.

Formula and Calculation

The calculation of Adjusted EPS generally begins with a company's GAAP-reported diluted EPS and then adds back or subtracts the per-share impact of specific items that management believes obscure underlying performance. There is no universally mandated formula for Adjusted EPS, as the adjustments are determined by individual companies. However, the conceptual formula is:

Where:

• Net Income (GAAP): The company's profit as reported in its financial statements according to GAAP.
• Adjustments (Net of Tax): These are the income or expense items added back or subtracted. Common adjustments often include:
  • Amortization of acquired intangible assets
  • Restructuring charges
  • One-time legal settlements
  • Gain or loss on the sale of assets
  • Stock-based compensation expenses
  • Significant tax adjustments
• Diluted Weighted-Average Shares Outstanding: The denominator used in the standard diluted earnings per share calculation, which accounts for all potential common shares.

Each adjustment made to derive Adjusted EPS should ideally be disclosed with its specific tax impact to arrive at a "net of tax" figure.

Interpreting Adjusted EPS

Interpreting Adjusted EPS involves understanding management's perspective on what constitutes "core" earnings and how these adjustments may influence the perceived profitability of the company. Analysts and investors often use Adjusted EPS to assess a company's underlying operational trends, free from the noise of non-recurring or non-cash events. For instance, a company undergoing a significant merger might report lower GAAP EPS due to substantial integration and acquisition costs. Adjusted EPS, by excluding these one-time expenses, could present a more favorable picture, suggesting that the underlying business remains strong.

However, a critical eye is necessary. Users of financial statements should examine the nature and consistency of the adjustments. Are they truly non-recurring, or do they represent expenses that are a regular part of doing business, albeit irregular in timing? The comparison of Adjusted EPS with analyst consensus estimates, which frequently incorporate similar adjustments, can also provide insight into how the market views the company's performance.

Hypothetical Example

Consider "Tech Solutions Inc.," a publicly traded software company. In its latest fiscal year, Tech Solutions Inc. reported a GAAP net income of $50 million and has 100 million diluted weighted-average shares outstanding. This would result in a GAAP EPS of $0.50.

However, during the year, Tech Solutions Inc. had the following notable items:

• A one-time legal settlement expense of $10 million (pre-tax).
• Restructuring charges of $5 million (pre-tax) related to a reorganization.
• A gain of $2 million (pre-tax) from the sale of a non-core asset.
• Assume a corporate tax rate of 25%.

Step-by-Step Calculation of Adjusted EPS:

1. Calculate the after-tax impact of each adjustment:

   • Legal settlement: $10 million * (1 - 0.25) = $7.5 million (expense)
   • Restructuring charges: $5 million * (1 - 0.25) = $3.75 million (expense)
   • Gain on asset sale: $2 million * (1 - 0.25) = $1.5 million (income)

2. Determine total net adjustments (after-tax):

   • Total adjustments = (-$7.5 million) + (-$3.75 million) + (+$1.5 million) = -$9.75 million

3. Adjust GAAP Net Income:

   • Adjusted Net Income = $50 million - (-$9.75 million) = $59.75 million

4. Calculate Adjusted EPS:

   • Adjusted EPS = $59.75 million / 100 million shares = $0.5975 per share

In this hypothetical example, Tech Solutions Inc.'s Adjusted EPS of $0.5975 is higher than its GAAP EPS of $0.50, reflecting the company's attempt to show a stronger operational performance by excluding what it considers extraordinary expenses.

Practical Applications

Adjusted EPS is widely used in various facets of finance and investing. For shareholders and prospective investors, it serves as a key metric for evaluating a company's ongoing profitability and predicting future performance. Many financial analysts and investors utilize Adjusted EPS as a primary input for their valuation models, such as price-to-earnings (P/E) ratios, believing it provides a more stable and comparable basis for analysis over time.

Companies frequently highlight Adjusted EPS in their quarterly earnings releases and investor presentations, alongside GAAP figures, to communicate what they view as their fundamental business performance. For example, Thomson Reuters' financial results often report Adjusted EPS, noting that it excludes certain gains, finance costs, and other adjustments to provide a clearer picture of their operational earnings⁴. This practice is part of broader financial reporting strategies aimed at managing investor expectations and providing insights into the economic drivers of the business.

Beyond investor communications, Adjusted EPS can also influence executive compensation plans, which are sometimes tied to non-GAAP performance metrics. It's also a significant point of discussion in financial analysis among industry professionals.

Limitations and Criticisms

Despite its widespread use, Adjusted EPS faces several significant limitations and criticisms. The primary concern stems from the lack of standardization and the inherent subjectivity involved in its calculation. Unlike GAAP, which follows a uniform set of accounting rules, there are no strict guidelines for what a company can or cannot exclude when calculating Adjusted EPS. This discretion allows companies to selectively remove items, potentially leading to a more favorable, albeit less complete, view of their financial health. Such practices can raise questions about earnings quality and the potential for "earnings management."

Critics argue that some companies might opportunistically exclude "normal, recurring cash operating expenses" or label ordinary business costs as "non-recurring" to inflate their Adjusted EPS, making their performance appear better than it truly is³. This lack of consistency across companies and even within the same company over different periods can hinder meaningful comparisons, a key principle of effective financial reporting. Academic research on the quality of non-GAAP earnings has explored whether these disclosures provide more informative or potentially misleading signals to investors². Furthermore, the CFA Institute's insights on non-GAAP financial measures highlight concerns among investors regarding the lack of comparability and the greater prominence often given to non-GAAP metrics over their GAAP counterparts¹. The concept of materiality also comes into play; sometimes, excluded items, while individually small, can cumulatively misrepresent a company's overall financial picture.

Adjusted EPS vs. GAAP EPS

The core difference between Adjusted EPS and GAAP EPS lies in the adjustments made to the net income figure. GAAP EPS is derived directly from the audited financial statements prepared according to Generally Accepted Accounting Principles, which provide a standardized framework for financial reporting. This means GAAP EPS includes all revenues and expenses recognized under these principles, regardless of their recurring nature or management's perception of their relevance to core operations.

In contrast, Adjusted EPS (often referred to as pro forma earnings in older contexts) is a non-GAAP measure where management selectively adds back or subtracts specific items from GAAP net income. These adjustments typically aim to remove the impact of events considered extraordinary, non-recurring, or non-operating, such as restructuring costs, gains or losses on asset sales, or specific litigation expenses. While Adjusted EPS is intended to offer a clearer view of a company's operational profitability, its calculation is subject to management's discretion. This can lead to variations in how different companies define and report their Adjusted EPS, making direct comparisons challenging without careful scrutiny of the underlying adjustments.

FAQs

Q: Why do companies report Adjusted EPS if they already report GAAP EPS?
A: Companies report Adjusted EPS to provide what they consider a clearer picture of their ongoing business operations by excluding items they believe are not indicative of their core performance, such as one-time charges or unusual gains. This can help investors focus on sustainable profitability.

Q: Are the adjustments made to calculate Adjusted EPS audited?
A: While the underlying GAAP net income is audited, the specific adjustments made to arrive at Adjusted EPS are typically not subjected to the same level of independent audit scrutiny as GAAP figures. Companies are required by the SEC to reconcile their non-GAAP measures to the most comparable GAAP measure.

Q: Can Adjusted EPS be higher or lower than GAAP EPS?
A: Yes. Adjusted EPS is typically higher than GAAP EPS because companies often exclude expenses (like restructuring charges or amortization of intangibles) that negatively impact GAAP earnings. However, if a company excludes a significant one-time gain, Adjusted EPS could be lower than GAAP EPS.

Q: Is Adjusted EPS regulated?
A: Yes, in the U.S., the SEC regulates the disclosure of non-GAAP financial measures, including Adjusted EPS. Companies must adhere to Regulation G and Item 10(e) of Regulation S-K, which require reconciliation to the most comparable GAAP measure and prohibit misleading presentations.

Q: How reliable is Adjusted EPS for investment decisions?
A: Adjusted EPS can offer valuable insights when used with caution. It is crucial to understand the specific adjustments a company makes and why, and to always compare it with the company's GAAP EPS and consider the context of its financial reporting. Relying solely on Adjusted EPS without examining the underlying GAAP figures and adjustments can be misleading.