Adjusted inflation adjusted earnings

What Is Adjusted Inflation-Adjusted Earnings?

Adjusted Inflation-Adjusted Earnings represent a company's financial performance, specifically its earnings, after accounting for the effects of inflation and then making further adjustments for non-recurring or non-operational items. This metric falls under the broader discipline of financial analysis, aiming to provide a more accurate picture of a company's sustainable profitability and its true purchasing power over time. By stripping out both the distorting impact of rising prices and one-off events, adjusted inflation-adjusted earnings offer a clearer view of underlying operational efficiency, making inter-period and inter-company comparisons more meaningful.

History and Origin

The concept of adjusting financial metrics for inflation gained prominence during periods of high and sustained inflation, particularly in the mid-to-late 20th century. Traditional historical cost accounting practices, which record assets and expenses at their original purchase price, became increasingly inadequate for reflecting true economic reality as price levels shifted dramatically. In such environments, financial statements prepared solely on a historical cost basis could present a misleading picture of a company's profitability and financial health.

Accounting bodies and regulators worldwide began exploring methods to incorporate inflation's impact into financial reporting. For instance, in the United States, the Financial Accounting Standards Board (FASB) issued Statement No. 33, "Financial Reporting and Changing Prices," in 1979, which mandated supplementary disclosure of certain inflation-adjusted financial information for large public companies. While this standard was later rescinded due to a decline in inflation rates and implementation complexities, the underlying principle that inflation distorts reported earnings persisted. Academic research has continued to investigate how inflation affects the relevance of accounting earnings, highlighting how historical cost accounting can distort the relationship between reported figures and actual economic value.⁶ The practice of making further "adjusted" calculations by analysts and investors reflects a continued effort to look beyond reported figures for a more robust understanding of performance.

Key Takeaways

• Adjusted inflation-adjusted earnings aim to present a company's profitability in terms of constant purchasing power, removing the distortions caused by inflation.
• The calculation involves deflating nominal earnings by a price index, such as the Consumer Price Index, and then adjusting for specific non-recurring or non-operational items.
• This metric provides a more accurate basis for evaluating a company's sustainable performance and for comparing results across different periods or entities, especially in inflationary environments.
• It offers insights into the true "real" growth of a business, free from the illusion of nominal gains.
• While not a standard GAAP or IFRS measure, it is a valuable analytical tool for investors and analysts seeking deeper financial understanding.

Formula and Calculation

The calculation of Adjusted Inflation-Adjusted Earnings typically involves two main steps: first, adjusting for inflation, and second, making non-recurring adjustments.

1. Inflation Adjustment (to get Inflation-Adjusted Earnings or Real Earnings):
   This step converts nominal earnings into real terms using a price index. The most common index used for general inflation is the Consumer Price Index (CPI).

   $$\text{Inflation-Adjusted Earnings} = \text{Nominal Earnings} \times \left( \frac{\text{Base Period CPI}}{\text{Current Period CPI}} \right)$$

   Where:

   • Nominal Earnings: The reported earnings (e.g., net income) from the income statement for the current period.
   • Base Period CPI: The Consumer Price Index for the period chosen as the reference base (e.g., a specific year or quarter).
   • Current Period CPI: The Consumer Price Index for the period for which earnings are being adjusted.

2. Adjustment for Non-Recurring Items (to get Adjusted Inflation-Adjusted Earnings):
   Once earnings are inflation-adjusted, further adjustments are made to exclude specific items that are considered non-operational, non-recurring, or otherwise distort the view of core business performance. These adjustments are similar to those made when calculating adjusted earnings per share (EPS) or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Examples include:

   • One-time gains or losses (e.g., sale of an asset, litigation settlements)
   • Restructuring charges
   • Impairment charges on assets
   • Non-cash items not directly tied to core operations (e.g., stock-based compensation, deferred tax adjustments, though some of these are debatable depending on the analyst's intent).
   $$\text{Adjusted Inflation-Adjusted Earnings} = \text{Inflation-Adjusted Earnings} \pm \text{Adjustments for Non-Recurring Items}$$

   The specific adjustments made will vary based on the company and the analyst's objective in assessing normalized performance.

Interpreting the Adjusted Inflation-Adjusted Earnings

Interpreting adjusted inflation-adjusted earnings provides a nuanced view of a company's financial health, moving beyond the superficiality of nominal figures. When analyzing these earnings, the focus shifts to the "real" growth and sustainable profitability of the business. If a company's nominal earnings are growing, but its adjusted inflation-adjusted earnings are stagnant or declining, it suggests that the apparent growth is merely a reflection of general price increases rather than an actual improvement in operational performance or an increase in return on investment.

This metric is particularly insightful for evaluating companies with long-lived assets, where depreciation charges based on historical costs can significantly understate the true economic cost of asset consumption during inflationary periods. By evaluating adjusted inflation-adjusted earnings, analysts can gauge whether a company is truly generating enough profit to replace its assets and expand its operations in real terms. It also helps investors understand their real purchasing power from dividends or retained earnings.

Hypothetical Example

Consider "Alpha Manufacturing Inc." which reported nominal earnings of $10 million in Year 1 and $12 million in Year 2.
Let's assume the Consumer Price Index (CPI) was 100 in Year 1 (base period) and rose to 110 in Year 2. Additionally, in Year 2, Alpha Manufacturing Inc. had a one-time gain of $500,000 from the sale of an old piece of equipment and incurred a $200,000 restructuring charge.

Step 1: Calculate Inflation-Adjusted Earnings for Year 2

• Nominal Earnings Year 2 = $12,000,000
• Base Period CPI (Year 1) = 100
• Current Period CPI (Year 2) = 110

This means that the $12 million in nominal earnings in Year 2 has the same purchasing power as approximately $10,909,091 did in Year 1.

Step 2: Calculate Adjusted Inflation-Adjusted Earnings for Year 2

Now, we adjust the inflation-adjusted earnings for the non-recurring items:

• Inflation-Adjusted Earnings (Year 2) = $10,909,091
• One-time Gain = +$500,000 (add back as it inflates nominal earnings)
• Restructuring Charge = -$200,000 (add back as it reduces nominal earnings)

For adjusted earnings, we typically remove items that are not part of core operations. The one-time gain from equipment sale should be subtracted, and the restructuring charge should be added back to reflect operating performance.

Comparing Year 1's initial earnings of $10,000,000 (which are already in base period terms) with Year 2's adjusted inflation-adjusted earnings of $10,609,091, Alpha Manufacturing Inc. shows a real operational earnings growth of approximately $609,091, despite the higher nominal figure of $12 million. This provides a much clearer picture of the company's underlying performance.

Practical Applications

Adjusted inflation-adjusted earnings are a crucial tool in various aspects of financial analysis and investment decision-making. Investors and analysts use this metric to:

• Assess True Growth: Evaluate whether a company's earnings growth is genuine or merely a product of [inflation]. This is vital for long-term investment strategies and assessing the sustainability of a business.
• Improve Valuation Models: Incorporate real earnings into valuation models, such as discounted cash flow (DCF) analysis, to derive more realistic intrinsic values for a company's stock, especially when projecting future cash flows.
• Compare Performance Across Time: Provide a consistent basis for comparing a company's performance over extended periods, neutralizing the impact of fluctuating price levels. This helps in understanding historical trends in profitability.
• Capital Allocation Decisions: For corporate managers, understanding adjusted inflation-adjusted earnings helps in making better decisions regarding capital expenditures and reinvestment, ensuring that investments truly enhance the company's real earning power rather than just keeping pace with rising costs.
• Economic Analysis: Economists and policymakers also use similar inflation-adjusted concepts when analyzing the overall health of an economy. For example, the Federal Reserve Bank of Minneapolis provides historical Consumer Price Index data, which is essential for adjusting nominal economic figures to understand real economic trends and inform monetary policy.⁵ Moreover, governmental bodies like the Securities and Exchange Commission (SEC) implement annual inflation adjustments to civil monetary penalties, acknowledging the changing value of money over time.⁴

Limitations and Criticisms

While offering valuable insights, adjusted inflation-adjusted earnings are not without limitations and criticisms:

• Subjectivity of Adjustments: The "adjusted" part of the metric introduces subjectivity. Different analysts may include or exclude various "non-recurring" items, leading to different adjusted figures. This lack of standardization can make comparisons between analyses difficult.
• Choice of Price Index: The accuracy of the inflation adjustment depends heavily on the chosen price index. While the Consumer Price Index (CPI) is common, it may not perfectly reflect the specific inflation rates faced by a particular company or industry (e.g., input costs vs. consumer prices).
• Complexity: Calculating and interpreting adjusted inflation-adjusted earnings adds complexity to financial analysis, requiring a deeper understanding of economic data and accounting principles beyond standard financial statements.
• Historical Cost Accounting Foundation: Even with inflation adjustments, the underlying balance sheet and income statement are often rooted in historical cost accounting. This means that asset values and associated depreciation, for example, might still not fully reflect current economic realities, especially for long-lived assets. Academics have explored how historical cost accounting, by relying on past transaction prices, can make financial reports less relevant during inflationary periods.³ The Financial Accounting Standards Board (FASB) has also provided guidance on determining when an economy is considered highly inflationary, which necessitates specific accounting adjustments, highlighting the challenges of traditional accounting in such environments.²
• Not a GAAP/IFRS Standard: Since adjusted inflation-adjusted earnings are a non-standard, analytical metric, they are not typically reported by companies themselves. This means analysts must perform the calculations, which can be time-consuming and require access to specific data, such as historical CPI figures.

Adjusted Inflation-Adjusted Earnings vs. Nominal Earnings

The primary distinction between Adjusted Inflation-Adjusted Earnings and Nominal Earnings lies in their treatment of inflation and non-core items.

Nominal earnings reflect the face value of a company's profits in current dollars, making them susceptible to the "inflation illusion" where growth might appear strong simply due to rising prices, not increased volume or efficiency. Adjusted inflation-adjusted earnings, conversely, strip away these monetary distortions, revealing the true operational performance in terms of constant purchasing power.

FAQs

Q: Why are inflation adjustments important for earnings?
A: Inflation erodes the purchasing power of money over time. Without adjusting for it, a company's reported nominal earnings can appear to grow simply because prices are rising, not necessarily because the business is performing better in real terms. Adjustments help reveal the true underlying economic performance.

Q: Is Adjusted Inflation-Adjusted Earnings a standard financial metric?
A: No, it is not a standard metric required by accounting principles like GAAP or IFRS for typical financial reporting. It is primarily an analytical tool used by investors and analysts to gain deeper insights into a company's performance and to facilitate more meaningful comparisons over time and across companies.

Q: What is the difference between "real earnings" and "adjusted inflation-adjusted earnings"?
A: "Real earnings" typically refers to nominal earnings that have been deflated by a general price index (like the Consumer Price Index) to account for inflation. "Adjusted inflation-adjusted earnings" takes this a step further by also removing the impact of specific non-recurring or non-operational items, providing an even clearer view of core, sustainable profitability in real terms.

Q: How does the Consumer Price Index (CPI) relate to adjusted inflation-adjusted earnings?
A: The CPI is a common measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. It is frequently used as the deflator in the calculation of inflation-adjusted earnings to convert nominal monetary values into constant purchasing power units. The U.S. Bureau of Labor Statistics (BLS) collects and publishes CPI data.¹