Adjusted operating margin

What Is Adjusted Operating Margin?

Adjusted operating margin is a non-GAAP (Generally Accepted Accounting Principles) financial measure that provides insights into a company's underlying profitability from its core business operations. It is calculated by taking a company's operating income and adjusting it for certain non-recurring, non-cash, or unusual items that may distort the view of ongoing performance. As a key metric within financial analysis, adjusted operating margin aims to offer a clearer picture of how efficiently a company manages its sales and operating expenses before accounting for non-operational factors like interest and taxes.

History and Origin

The concept of "adjusted" financial measures, including adjusted operating margin, largely evolved from companies' desires to present their financial performance in a way they believe more accurately reflects their ongoing operational trends, particularly when GAAP figures are impacted by one-time events or accounting nuances. The rise of complex business transactions, such as mergers, acquisitions, and large-scale restructuring charges, often led companies to report supplemental non-GAAP measures.

While companies argue these adjustments provide a more representative view, regulatory bodies, especially the U.S. Securities and Exchange Commission (SEC), have consistently focused on ensuring these measures are not misleading to investors. Since adopting Regulation G and Item 10(e) of Regulation S-K in 2003, the SEC has provided extensive guidance and updates, emphasizing that non-GAAP measures must be clearly reconciled to their most directly comparable GAAP counterparts and not presented with undue prominence. The SEC’s Division of Corporation Finance regularly updates its Compliance & Disclosure Interpretations (C&DIs) regarding non-GAAP financial measures, with significant updates occurring in December 2022 to clarify what constitutes a misleading non-GAAP measure and the proper presentation requirements., ¹⁰T⁹his ongoing regulatory scrutiny highlights the balance between providing flexible reporting and preventing potential investor deception.

Key Takeaways

• Adjusted operating margin offers a normalized view of a company's core operational profitability by excluding specific non-recurring or non-cash items.
• It is a non-GAAP financial measure, meaning it is not standardized under Generally Accepted Accounting Principles.
• Companies use adjusted operating margin to highlight underlying performance, but it requires careful scrutiny due to its subjective nature.
• The adjustments made to calculate adjusted operating margin can vary significantly between companies and industries, limiting direct comparability.
• Regulatory bodies like the SEC provide strict guidance on the disclosure and presentation of non-GAAP measures to ensure transparency.

Formula and Calculation

The formula for adjusted operating margin begins with operating income from the income statement, then adds back or subtracts specific items.

[
\text{Adjusted Operating Margin} = \frac{\text{Operating Income} + \text{Adjustments}}{\text{Revenue}} \times 100%
]

Where:

• Operating Income: This is a company's profit after subtracting operating expenses from its revenue, but before interest and taxes.
• Adjustments: These are typically non-recurring, non-cash, or unusual items that management believes distort the underlying operational performance. Common adjustments may include:
  • Restructuring charges (e.g., severance costs, facility closures)
  • Asset impairment charges
  • Gains or losses from asset sales
  • Stock-based compensation expenses (often treated as non-cash)
  • One-time legal settlements or regulatory fines
• Revenue: The total sales generated by the company during the period.

It is crucial for companies to clearly define and reconcile these adjustments to the most directly comparable GAAP measure.

⁸## Interpreting the Adjusted Operating Margin

Interpreting adjusted operating margin involves understanding the quality and nature of the adjustments made. A higher adjusted operating margin generally indicates that a company is more efficient at generating profits from its primary operations, excluding extraordinary events. This metric can be particularly useful when comparing a company's performance over several periods or against industry benchmarks, as it attempts to normalize the figures by removing distortions.

However, users must scrutinize the adjustments. If a company consistently excludes certain "one-time" expenses that seem recurring, the adjusted operating margin might present an overly optimistic view of its sustainable profitability. For instance, the SEC has challenged companies that exclude "normal, recurring cash operating expenses" from their non-GAAP measures, noting that such exclusions could be misleading. A⁷nalysts often compare a company's adjusted operating margin to its unadjusted operating margin, as well as to its gross margin and net income, to gain a comprehensive understanding of its financial health.

Hypothetical Example

Consider a hypothetical technology company, "TechInnovate Inc.," which reported the following for the fiscal year:

• Revenue: $500 million
• Operating Income (GAAP): $70 million

During the year, TechInnovate also incurred:

• $5 million in restructuring charges related to optimizing its workforce.
• $3 million in one-time legal settlement expenses.

To calculate its adjusted operating margin, TechInnovate's management decides to exclude these two items, considering them non-recurring and not reflective of ongoing operations.

Step-by-step calculation:

1. Identify operating income: $70 million
2. Identify adjustments:
   • Restructuring charges: $5 million (added back as they reduced operating income)
   • Legal settlement: $3 million (added back as they reduced operating income)
3. Calculate Adjusted Operating Income:
   $70 \text{ million} + $5 \text{ million} + $3 \text{ million} = $78 \text{ million}
4. Calculate Adjusted Operating Margin:
   [
   \frac{$78 \text{ million}}{$500 \text{ million}} \times 100% = 15.6%
   ]

In this example, TechInnovate's adjusted operating margin is 15.6%, compared to its GAAP operating margin of 14% ($70 million / $500 million). This adjusted figure aims to show that, absent the specific one-time events, the company's core operations were more profitable.

Practical Applications

Adjusted operating margin is frequently used in several areas of finance and investing:

• Performance Evaluation: Investors and analysts use adjusted operating margin to assess a company's operational efficiency and identify trends, especially when comparing performance across different quarters or years that may be affected by unusual events. This helps to filter out noise and focus on the sustainable earnings power of a company.
• Valuation Models: In financial modeling, adjusted operating income (the numerator for the adjusted operating margin) is often used as a proxy for a company's earnings before interest and taxes (EBIT) when forecasting future cash flows, particularly in discounted cash flow (DCF) models.
• Credit Analysis: Lenders and credit rating agencies may look at adjusted operating margin to gauge a company's ability to generate sufficient cash from its core business operations to cover its debts.
• Management Compensation: In some cases, management compensation or bonus structures may be tied to adjusted financial metrics, including adjusted operating margin, to incentivize focus on operational performance stripped of external or infrequent impacts.

However, the use of such non-GAAP metrics is subject to considerable oversight. The SEC explicitly states that companies must not present non-GAAP measures in a way that is misleading or more prominent than the comparable GAAP measures, and they must provide clear reconciliations.,
^6
5## Limitations and Criticisms

While adjusted operating margin can offer valuable insights, it comes with notable limitations and criticisms:

• Subjectivity of Adjustments: The primary criticism is the subjective nature of what constitutes an "adjustment." Management has discretion over which items to exclude, potentially leading to a portrayal of profitability that is more favorable than reality. As PwC notes, the appropriateness of adjustments, especially those deemed non-recurring, is a frequent point of contention in SEC comment letters.
  *⁴ Comparability Issues: Because there is no standardized definition for "adjusted" figures under GAAP, adjusted operating margins can vary widely even between similar companies in the same industry. This makes direct comparisons challenging and can obscure true relative performance.
• Exclusion of Legitimate Costs: Some critics argue that frequently excluded items, such as stock-based compensation or even some restructuring charges, are recurring aspects of a company's operations and should not be dismissed as "one-time" events. Excluding them can inflate the perceived profitability and cash generation of the business operations.
• Regulatory Scrutiny: The SEC continues to monitor and issue guidance on non-GAAP measures, emphasizing that adjustments should not create "individually tailored accounting principles" or exclude "normal, recurring cash operating expenses.", ³N²on-compliance can lead to enforcement actions, as seen in cases where companies misclassified expenses to boost non-GAAP earnings.

¹## Adjusted Operating Margin vs. Operating Margin

The key difference between adjusted operating margin and standard operating margin lies in the adjustments made to the operating income.

While operating margin provides a straightforward, audited view of operational performance, adjusted operating margin seeks to offer a management's perspective on underlying performance, which can be useful but also requires careful analysis of the adjustments.

FAQs

Why do companies report Adjusted Operating Margin?

Companies report adjusted operating margin to provide investors with a view of their financial performance that they believe better reflects the ongoing, core aspects of their business operations. They often exclude one-time events, non-cash charges, or other unusual items that might obscure the underlying profitability.

Is Adjusted Operating Margin more reliable than GAAP Operating Margin?

Not necessarily. While adjusted operating margin can offer valuable insights by stripping out noise, it is less reliable in terms of standardization and auditability compared to GAAP operating margin. The adjustments are at the discretion of management, which can introduce subjectivity. For a complete picture, it is best to consider both metrics and understand the nature of any adjustments made.

What kind of adjustments are typically made to calculate Adjusted Operating Margin?

Common adjustments include adding back non-recurring items like restructuring charges, asset impairment charges, one-time legal settlements, or sometimes non-cash expenses such as stock-based compensation. The goal is to remove items that are not considered part of the company's regular, ongoing operations.

How does the SEC regulate Adjusted Operating Margin?

The SEC regulates adjusted operating margin, as it is a non-GAAP measure, through rules like Regulation G and Item 10(e) of Regulation S-K. These rules require companies to clearly reconcile adjusted figures to their most directly comparable GAAP measures, explain why the adjusted measure is useful, and ensure that the non-GAAP measure is not presented with greater prominence than its GAAP counterpart. The SEC frequently issues guidance to clarify these requirements.

Can Adjusted Operating Margin be used for company valuation?

Yes, adjusted operating margin (or adjusted operating income) is often used in valuation models, such as discounted cash flow (DCF) analysis. By normalizing earnings, analysts can forecast a more stable future cash flow from operations, which can then be used to estimate a company's intrinsic value. However, analysts must carefully assess the quality and consistency of these adjustments over time.