Adjusted p e ratio

What Is Adjusted P/E Ratio?

The Adjusted P/E Ratio is a valuation metric that modifies the traditional Price-to-Earnings Ratio by altering the "earnings" component to exclude certain non-recurring or non-operating items. This financial ratio belongs to the broader category of Financial Ratios and is often used in Valuation and Financial Analysis to provide a clearer picture of a company's sustainable profitability. Companies and analysts often adjust earnings to reflect what they believe is the "core" or "normalized" earnings power of a business, removing distortions that might otherwise obscure the underlying performance. The objective behind using an Adjusted P/E Ratio is to make a company's profitability more comparable across different periods or against competitors.

History and Origin

The concept of adjusting earnings for valuation purposes is not new, but its prominence increased significantly in the late 1990s and early 2000s, particularly during periods of rapid technological change and corporate restructuring. As companies began to report "pro forma" or "adjusted" earnings that often excluded various expenses, concerns grew about the potential for misleading investors. For instance, the infamous Enron scandal in the early 2000s highlighted how aggressive accounting practices and the use of off-balance-sheet entities could obscure a company's true financial health, leading to its eventual collapse.¹⁶

In response to such events and the increasing use of non-GAAP (Generally Accepted Accounting Principles) measures, regulatory bodies like the U.S. Securities and Exchange Commission (SEC) have provided guidance to ensure that companies offer adequate disclosure and reconciliation of adjusted figures to their GAAP counterparts. The SEC's Compliance & Disclosure Interpretations regarding non-GAAP financial measures emphasize the importance of presenting the most directly comparable GAAP financial measure with equal or greater prominence, and reconciling the non-GAAP measure to the GAAP measure.¹⁵,¹⁴,,¹³,¹² This regulatory scrutiny aims to balance the desire for informative "core" earnings figures with the need for transparency and comparability.

Key Takeaways

• The Adjusted P/E Ratio modifies a company's earnings to exclude non-recurring or unusual items.
• It aims to provide a clearer view of a company's ongoing operational profitability.
• Adjusted earnings are a non-GAAP measure and require careful scrutiny by investors.
• While potentially offering better insight into core performance, adjusted figures can be subjective and may obscure actual costs.
• Comparing a company's Adjusted P/E Ratio with its historical averages and industry peers can offer valuable insights for investment decisions.

Formula and Calculation

The formula for the Adjusted P/E Ratio is a modification of the standard price-to-earnings ratio:

Where:

• Current Share Price: The prevailing market price of one share of the company's stock.
• Adjusted Earnings Per Share (Adjusted EPS): Calculated by taking a company's reported Earnings Per Share (EPS) and adding back or subtracting out specific non-recurring, non-cash, or unusual items that management believes distort the underlying operational performance. These adjustments might include:
  • Restructuring charges
  • Impairment charges
  • Gains or losses from asset sales
  • One-time legal settlements
  • Stock-based compensation (though this is often a recurring expense, some companies adjust for it)
  • Amortization of acquired intangible assets

The process of determining "adjusted earnings" involves starting with GAAP Net Income and then making discretionary additions or subtractions. For example, if a company wants to arrive at its adjusted earnings, it might add back a significant one-time lawsuit expense that hit its Income Statement.

Interpreting the Adjusted P/E Ratio

Interpreting the Adjusted P/E Ratio involves understanding that it aims to normalize a company's earnings, providing a perspective on its "true" or sustainable profitability. A lower Adjusted P/E Ratio might suggest that a company is undervalued relative to its core earnings, while a higher one could indicate that investors expect significant future growth or that the stock is overvalued.

When evaluating this ratio, it's crucial to understand what adjustments have been made and why. Companies often use adjusted earnings to highlight their operational performance by excluding what they deem "non-core" items.¹¹ However, these adjustments can be subjective. For instance, some companies might exclude stock-based compensation, arguing it's a non-cash expense, even though it represents a real cost to Shareholders by diluting their ownership.¹⁰ Analysts performing Fundamental Analysis will scrutinize these adjustments and often recalculate adjusted earnings based on their own criteria to ensure comparability across peers and over time.

Hypothetical Example

Let's consider a hypothetical company, "InnovateTech Inc.," which recently reported its financial results.

InnovateTech's financial data:

• Current Share Price: $150
• GAAP Earnings Per Share (EPS): $8.00
• One-time legal settlement expense (after-tax): $1.50 per share
• Gain from sale of non-core asset (after-tax): $0.50 per share

To calculate InnovateTech's Adjusted EPS, management decides to exclude the one-time legal settlement expense and the gain from the sale of the non-core asset, arguing these are not reflective of ongoing operations.

Step 1: Calculate Adjusted EPS
Adjusted EPS = GAAP EPS + One-time Legal Settlement Expense - Gain from Sale of Non-Core Asset
Adjusted EPS = $8.00 + $1.50 - $0.50 = $9.00

Step 2: Calculate Adjusted P/E Ratio
Adjusted P/E Ratio = Current Share Price / Adjusted EPS
Adjusted P/E Ratio = $150 / $9.00 = 16.67x

In this scenario, InnovateTech's Adjusted P/E Ratio of 16.67x is lower than its GAAP P/E Ratio (150 / 8 = 18.75x). This suggests that the one-time legal expense had a greater negative impact on GAAP earnings than the one-time gain had a positive impact, and removing both results in a higher, "normalized" earnings figure. An investor analyzing this would then compare this 16.67x to InnovateTech's historical Adjusted P/E and to the Adjusted P/E ratios of its industry competitors to assess its relative valuation. The transparency of the Financial Statements and the accompanying footnotes are crucial for understanding these adjustments.

Practical Applications

The Adjusted P/E Ratio is widely applied in various areas of financial analysis and investment decision-making. Investors and analysts use it to gain a more consistent view of a company's earning power, particularly when comparing companies with different accounting treatments or when a company experiences significant one-off events.

• Investment Screening: Portfolio managers might use adjusted earnings figures in their quantitative models to screen for companies that appear undervalued based on their core profitability, filtering out the noise from unusual charges or gains.
• Industry Comparison: When comparing companies within the same industry, where specific recurring "non-GAAP" adjustments (like stock-based compensation in tech or restructuring costs in manufacturing) are common, the Adjusted P/E Ratio can facilitate an "apples-to-apples" comparison. Financial professionals often develop their own adjusted earnings calculations for better peer analysis.
• Mergers & Acquisitions (M&A): In M&A due diligence, buyers frequently adjust a target company's earnings to understand its normalized operating income, free from acquisition-related expenses or integration costs, to arrive at a realistic valuation for the acquisition.
• Credit Analysis: Lenders may look at adjusted earnings to assess a company's ability to generate consistent cash flows to service its debt, focusing on sustainable earnings rather than one-time windfalls or losses.⁹
• Management Compensation: Executive compensation plans may sometimes be tied to adjusted earnings targets, incentivizing management to focus on operational performance, although this practice also faces scrutiny regarding its potential for manipulation.

While proponents argue that adjusted earnings provide a clearer picture of a company's ongoing performance, investors must exercise diligence to understand the nature of the adjustments.⁸ The ability to consistently generate cash flow from operations, as reflected in the Cash Flow Statement, remains a vital indicator of a company's financial health, often considered less susceptible to the subjective interpretations inherent in adjusted earnings.

Limitations and Criticisms

Despite its utility in certain contexts, the Adjusted P/E Ratio has significant limitations and faces considerable criticism. The primary concern revolves around the discretionary nature of the adjustments. Management has considerable leeway in deciding what constitutes a "non-recurring" or "non-operating" item to be excluded from GAAP earnings, which can lead to figures that may not accurately reflect a company's true economic performance.⁷

• Subjectivity and Opportunism: The criteria for what to include or exclude can be subjective and, in some cases, opportunistic. Companies might consistently exclude certain "one-time" expenses that, in reality, are normal and recurring costs of doing business, such as frequent restructuring charges or stock-based compensation, which is a real cost to shareholders.⁶ This can make the adjusted earnings appear more favorable than the GAAP reported numbers.
• Lack of Comparability: While intended to enhance comparability, the varied definitions of "adjusted earnings" across different companies and even within the same company over time can make meaningful comparisons difficult without detailed analysis of each adjustment. The SEC has noted that non-GAAP measures are not always consistent across, or comparable with, non-GAAP measures disclosed by other companies.⁵
• Overstating Performance: Critics argue that adjusted earnings often overstate a company's true profitability. For example, a PwC report noted that the way adjusted earnings are calculated can make them "susceptible to bias or misinterpretation."⁴ This can lead investors to misjudge a company's financial health and potentially overvalue its stock.
• Regulatory Scrutiny: Due to the potential for misleading investors, adjusted earnings (as non-GAAP measures) are under continuous scrutiny from regulatory bodies like the SEC, which requires companies to reconcile these figures clearly to their GAAP equivalents and ensure they are not misleading.

Therefore, relying solely on the Adjusted P/E Ratio without a thorough understanding of the underlying adjustments and a comparison with GAAP figures can lead to flawed investment conclusions.³

Adjusted P/E Ratio vs. P/E Ratio

The distinction between the Adjusted P/E Ratio and the traditional P/E Ratio lies in the earnings component used in the calculation. Both ratios aim to assess how much investors are willing to pay for each dollar of a company's earnings, serving as key metrics in investment analysis.

While the standard P/E Ratio reflects the company's profitability as reported under established accounting principles, the Adjusted P/E Ratio seeks to offer a more normalized view by filtering out specific financial events that are perceived as distorting or non-representative of ongoing operations. The key confusion often arises from companies promoting their adjusted figures, which can sometimes present a more favorable picture than their GAAP earnings. Investors should always consider both ratios to gain a comprehensive understanding of a company's financial standing and earnings quality.

FAQs

What types of adjustments are commonly made to earnings for the Adjusted P/E Ratio?

Common adjustments include adding back one-time legal settlements, restructuring charges, impairment losses, and subtracting one-time gains from asset sales. Some companies also adjust for non-cash expenses like stock-based compensation or amortization of acquired Intangible Assets.

Why do companies report adjusted earnings if GAAP earnings exist?

Companies often report adjusted earnings (non-GAAP measures) to highlight what they consider their "core" operational performance, believing that certain items distort the true profitability picture. They argue it helps investors understand the underlying business trends and make more informed investment decisions.²

Are adjusted earnings figures audited?

No, typically the "adjusted" portion of earnings figures is not audited by external auditors. Only the GAAP financial statements, from which these adjustments are derived, undergo a formal audit process. This is why investors must scrutinize the reconciliation provided by companies between their GAAP and non-GAAP figures.

Can an Adjusted P/E Ratio be misleading?

Yes, an Adjusted P/E Ratio can be misleading if the adjustments made are not clearly disclosed, are inconsistent, or if they regularly exclude expenses that are, in fact, recurring costs of doing business. Companies can potentially use subjective adjustments to present a more favorable financial picture.¹

How does the Adjusted P/E Ratio relate to earnings quality?

The Adjusted P/E Ratio aims to reflect higher Earnings Quality by focusing on sustainable, recurring earnings. However, poorly justified or aggressive adjustments can actually diminish earnings quality, making it harder for investors to assess the reliability of reported profits. High earnings quality generally means earnings are persistent, predictable, and reflective of true economic performance.