Adjusted future earnings

What Is Adjusted Future Earnings?

Adjusted Future Earnings refer to a company's projected profits that have been modified to exclude certain financial items, aiming to provide a more accurate and representative view of its sustainable financial performance. This metric is a crucial component within the broader field of business valuation and financial analysis, particularly when assessing a company's intrinsic value or potential for long-term profitability. By making these adjustments, analysts and investors can better understand the earnings generated from a company's regular core operations, free from the distortions of one-time events or non-operating revenues and expenses. The goal of deriving Adjusted Future Earnings is to establish a normalized earnings base upon which future growth can be more reliably estimated.

History and Origin

The concept of adjusting reported earnings for analytical purposes has long been a practice in financial analysis, predating formal accounting standards. As businesses grew in complexity and financial statements became more intricate, the need to differentiate between sustainable operational profits and transient financial events became apparent. The formalization of these adjustments evolved alongside the development of Generally Accepted Accounting Principles (GAAP)) and the increasing demand for clearer insights into a company's underlying profitability.

While there isn't a single definitive "invention" date for Adjusted Future Earnings, the practice gained significant traction with the rise of modern equity research and valuation methodologies in the 20th century. Regulators, such as the U.S. Securities and Exchange Commission (SEC), also played a role by establishing guidelines and safe harbors for companies making "forward-looking statements" about their future financial performance, recognizing their importance to investors while also requiring cautionary language. For instance, the Private Securities Litigation Reform Act of 1995 introduced a safe harbor for certain forward-looking statements made by companies, encouraging transparency while offering protection against frivolous lawsuits, provided such statements have a reasonable basis and include meaningful cautionary language.¹⁶ This regulatory environment underscored the importance of distinguishing between actual, reported earnings and forward-looking projections, which often necessitate adjustments.

Key Takeaways

• Adjusted Future Earnings provide a normalized view of a company's projected profitability by removing the impact of non-recurring items and non-operational activities.
• This metric is vital for accurate business valuation, as it focuses on sustainable earning capacity rather than temporary fluctuations.
• Adjustments often include one-time gains or losses, unusual expenses, or discretionary items that do not reflect ongoing operations.
• Analysts use Adjusted Future Earnings to build more reliable financial modeling and forecast future performance for investors.
• Despite its benefits, the process of calculating Adjusted Future Earnings involves subjectivity, as the classification of certain items as "non-recurring" can vary.

Formula and Calculation

Adjusted Future Earnings do not adhere to a single, universally mandated formula, but rather represent a process of modifying conventional earnings forecasts. The core idea is to normalize a company's expected net income for future periods by adding back or subtracting items that are considered non-operating, non-recurring, or discretionary.

While there is no precise mathematical formula to determine the range of normalized earnings, the process typically begins with a company's projected earnings (e.g., earnings per share or net income) and then applies qualitative and quantitative analysis to identify and adjust for specific items.¹⁴, ¹⁵

A simplified representation of the adjustment process might look like this:

Where:

• Projected Net Income: The forecasted net profit of the company before any adjustments, often based on historical trends, management guidance, and analyst estimates.
• Adjustments for Non-Recurring Items: These include one-time gains or losses that are unlikely to repeat, such as profits or losses from the sale of assets, restructuring charges, or unusual legal settlements.
• Adjustments for Non-Operating Items: These refer to income or expenses not directly related to the company's primary business activities, such as income from investments in other companies or expenses from discontinued operations.
• Adjustments for Discretionary Expenses: These might involve expenses that a new owner or normalized operation would eliminate or alter, such as excessive executive compensation or owner-specific benefits that exceed market rates.

The objective is to arrive at a "maintainable" or "normalized" earnings figure that can serve as a more stable base for business valuation.¹³

Interpreting the Adjusted Future Earnings

Interpreting Adjusted Future Earnings involves understanding what the adjusted figure signifies about a company's sustainable profitability. This metric is not about predicting a company's exact future profit, but rather about presenting a clearer picture of its underlying earning power by removing unusual noise. When a company's future earnings are adjusted, it allows analysts to assess how much profit the business is expected to generate from its ongoing operations, free from the impact of extraordinary events.

A higher Adjusted Future Earnings figure, after normalizing for various factors, generally indicates a stronger underlying business that can generate consistent profits. Conversely, if a company's reported future earnings are significantly higher than its Adjusted Future Earnings, it suggests that a substantial portion of those projected profits might stem from unsustainable or one-off sources. Investors should evaluate these adjusted figures in the context of the company's industry, its growth prospects, and broader economic conditions. The aim is to derive a figure that reflects the true economic benefit available to the company, which can then be used in various valuation models.¹² Furthermore, comparing a company's Adjusted Future Earnings over several periods can reveal trends in its operational efficiency and long-term viability, providing a more robust basis for investment decisions.

Hypothetical Example

Consider "Tech Innovations Inc.," a publicly traded software company. For the upcoming fiscal year, external analysts initially project Tech Innovations Inc. to have a net income of $100 million. However, a deeper dive into their projections reveals two significant factors:

1. One-Time Patent Sale: The company is expected to finalize the sale of a non-core patent portfolio, which will result in a projected one-time gain of $15 million. This is an extraordinary item, not part of their regular software development and sales.
2. Discretionary Executive Bonus Pool: The projected expenses include a $5 million bonus pool for executives, which is unusually high and is considered discretionary for the upcoming year, potentially to be reduced or reallocated in future periods.

To calculate the Adjusted Future Earnings for Tech Innovations Inc.:

• Start with Projected Net Income: $100 million
• Subtract Non-Recurring Gain: The $15 million gain from the patent sale is not expected to recur in subsequent years, so it's removed to reflect core profitability.
  • $100 million - $15 million = $85 million
• Add Back Discretionary Expense: The $5 million executive bonus, if deemed excessive or non-essential for normal operations, could be added back to reflect the full earning capacity without this specific discretionary allocation.
  • $85 million + $5 million = $90 million

Therefore, the Adjusted Future Earnings for Tech Innovations Inc. would be $90 million. This adjusted figure provides a more realistic representation of the company's sustainable profitability from its ongoing software business, allowing investors to make more informed investment decisions by focusing on earnings that are expected to continue consistently.

Practical Applications

Adjusted Future Earnings are widely used in various financial contexts to gain a clearer understanding of a company's true earning power.

1. Business Valuation: A primary application is in valuing businesses. When using income-based valuation methods, such as the capitalization of earnings or the Discounted Cash Flow (DCF)) model, Adjusted Future Earnings provide a more reliable base for projecting sustainable future benefits. Valuators adjust historical earnings to arrive at a "maintainable earnings" figure that is more indicative of future performance.¹⁰, ¹¹
2. Mergers and Acquisitions (M&A): In M&A deals, potential buyers analyze the Adjusted Future Earnings of a target company to determine its fair value. This helps them understand the recurring profitability of the acquired entity, excluding any one-off events or owner-specific expenses that might inflate or depress reported figures.
3. Lending Decisions: Financial institutions may review Adjusted Future Earnings when assessing a company's ability to service debt. Lenders want to ensure that the projected cash flow for repayment is based on stable, ongoing operations.
4. Performance Analysis: Companies themselves can use Adjusted Future Earnings internally to set more realistic budgets, evaluate divisional performance, and make strategic decisions based on core profitability rather than transient factors.
5. Regulatory Scrutiny: While not a GAAP measure, the underlying principles of isolating core earnings are implicitly acknowledged by regulators. For example, the Federal Open Market Committee (FOMC) of the U.S. Federal Reserve regularly publishes economic projections for GDP, inflation, and unemployment, which indirectly influence broader corporate earnings forecasts and the need for realistic assessments.⁹ Economic slowdowns, for instance, can lead to downward revisions in corporate profit forecasts, necessitating careful adjustments by analysts.⁸

Limitations and Criticisms

Despite their utility, Adjusted Future Earnings are not without limitations and criticisms. The primary concern revolves around the inherent subjectivity in determining which items to adjust. While some adjustments, like one-time asset sales or clear extraordinary legal settlements, are straightforward, others can be ambiguous. The lack of a standardized definition or mandatory reporting guidelines for Adjusted Future Earnings means that different analysts or companies may make varying adjustments, leading to inconsistent comparisons.⁷

Critics argue that companies might be tempted to use earnings adjustments to present a more favorable picture of their financial performance, potentially excluding recurring "non-recurring" items or operational expenses that are, in reality, integral to the business. This can obscure the true financial health and risk profile of a company, leading to inflated investor expectations. Research indicates that financial analysts' earnings forecasts often exhibit an optimistic bias and may not always be accurate, particularly over longer horizons.³, ⁴, ⁵, ⁶ Some studies even suggest that analysts might "low-ball" earnings forecasts closer to the actual release date to enable companies to "beat the street," which can further skew the perception of future profitability.²

Furthermore, projecting future earnings, even after adjustments, is inherently challenging.¹ Unforeseen macroeconomic shifts, rapid technological changes, new regulatory environments, or intense competitive pressures can significantly alter a company's earning potential, rendering even carefully adjusted forecasts inaccurate. The accuracy of Adjusted Future Earnings is heavily dependent on the quality of underlying assumptions about future economic conditions and specific industry trends.

Adjusted Future Earnings vs. Discounted Cash Flow (DCF)

Adjusted Future Earnings and Discounted Cash Flow (DCF)) are both critical concepts in business valuation, but they represent different stages or components of the valuation process. The primary distinction lies in what each method fundamentally calculates and its focus.

Adjusted Future Earnings refer to the adjusted forecast of a company's future profits. This is an input metric derived by normalizing expected earnings by removing non-recurring, non-operational, or discretionary items. The goal is to arrive at a clean, sustainable earnings figure that represents the core profitability of the business for a specific future period. It focuses on the "earnings" line item, which can be influenced by accounting policies.

In contrast, the Discounted Cash Flow (DCF) model is a comprehensive valuation methodology that calculates the present value of a company's projected future cash flow. The DCF model projects free cash flows (cash available to investors after all expenses and reinvestments) over a forecast period and then discounts these future cash flows back to the present using a discount rate that reflects the risk of the investment. Unlike earnings, cash flow is often considered a more direct measure of value creation, as it is less susceptible to accounting accruals and non-cash items. While Adjusted Future Earnings might serve as a starting point or a check for developing cash flow projections within a DCF model, the DCF goes further by converting those projected profits (or a derivation of them) into cash flows and then discounting them to a current value.

FAQs

Q1: Why are earnings "adjusted" for future projections?

A1: Earnings are adjusted for future projections to provide a more accurate and normalized view of a company's sustainable profitability from its ongoing core operations. This removes the influence of one-time events, non-operating income or expenses, and discretionary items that might not reflect the company's recurring earning capacity.

Q2: What types of items are typically adjusted?

A2: Common adjustments include one-time gains or losses (e.g., from asset sales), restructuring charges, significant legal settlements, extraordinary tax benefits or liabilities, and non-recurring expenses or income that are not part of a company's regular business activities. Adjustments may also be made for certain discretionary expenses, like abnormal executive compensation.

Q3: How do Adjusted Future Earnings help investors?

A3: Adjusted Future Earnings help investors by presenting a clearer, more reliable picture of a company's expected financial performance. This normalized figure is used in financial modeling and valuation techniques, aiding investors in making more informed investment decisions by focusing on sustainable earnings rather than transient fluctuations.