Adjusted price to earnings

What Is Adjusted Price to Earnings?

Adjusted Price to Earnings is a modified version of the traditional Price-to-Earnings (P/E) Ratio that aims to provide a more accurate and normalized view of a company's financial performance. It falls under the broader category of Financial Ratios used in Fundamental Analysis and Equity Valuation. Unlike the standard P/E, which uses reported net income, the Adjusted Price to Earnings metric typically excludes certain non-recurring, unusual, or extraordinary items from the Earnings Per Share (EPS) calculation. The goal of adjusted price to earnings is to remove the impact of events that are not expected to reflect the company's core, ongoing profitability, thereby offering investors a clearer picture of its sustainable earning power.

History and Origin

The practice of adjusting reported earnings, and consequently the Price to Earnings ratio, evolved as companies sought to present their financial results in a way that highlighted their underlying operational performance, free from significant one-off events. This gave rise to what are commonly known as Non-GAAP Measures. While companies have historically made certain adjustments, formal guidance and scrutiny from regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), intensified in the early 2000s to ensure transparency and comparability. For instance, the SEC introduced Regulation G in 2003, which requires companies to reconcile non-GAAP measures to their most directly comparable Generally Accepted Accounting Principles (GAAP) equivalents⁹. This was a direct response to concerns about potential manipulation and the need for clear financial reporting. Prior to this, accounting standards themselves also evolved, with the Financial Accounting Standards Board (FASB) eliminating the concept of "Extraordinary Items" from U.S. GAAP in January 2015, recognizing that such classifications were rarely met in practice and often confused financial statement users⁷, ⁸.

Key Takeaways

• Adjusted Price to Earnings provides a normalized view of a company's earnings by excluding non-recurring or unusual items.
• It aims to reflect a company's sustainable earning power, aiding in long-term Valuation.
• Companies typically disclose the adjustments made, which can include Restructuring Charges, Goodwill Impairment, or one-time gains/losses.
• Analysts and investors use Adjusted Price to Earnings to compare companies within the same industry more effectively, as it removes idiosyncratic events.
• Despite its usefulness, the calculation of adjusted price to earnings is subject to management's discretion, necessitating careful scrutiny.

Formula and Calculation

The formula for Adjusted Price to Earnings is a modification of the standard P/E ratio, where the reported earnings per share are adjusted to exclude or include specific items.

$\text{Adjusted Price to Earnings} = \frac{\text{Current Share Price}}{\text{Adjusted Earnings Per Share}}$

Where:

• Current Share Price: The current market price of one share of the company's stock.
• Adjusted Earnings Per Share: Calculated by taking the company's GAAP Earnings Per Share and adding back or subtracting non-recurring, non-operating, or unusual items.

For example, if a company reports a net income on its Income Statement that includes a large, one-time gain from the sale of an asset, this gain would typically be removed from the earnings figure to arrive at an adjusted earning. Similarly, significant, non-recurring expenses like large legal settlements or transformation charges are often excluded.⁶

Interpreting the Adjusted Price to Earnings

Interpreting the Adjusted Price to Earnings ratio involves understanding what the adjustments signify about a company's core profitability. A lower adjusted P/E compared to the unadjusted P/E suggests that the reported earnings include significant negative, one-time impacts that analysts believe are not indicative of future performance. Conversely, if the adjusted P/E is higher, it indicates that reported earnings benefited from non-recurring positive events.

Investors typically use the adjusted price to earnings ratio to gain a clearer understanding of a company's earnings power from its ongoing operations. For example, if a company had a major Restructuring Charge in a given year that depressed its reported earnings, adjusting for this charge provides a P/E that reflects what the company would have earned without that specific, non-operational event. This allows for better comparisons with historical performance or with peers who may not have faced similar one-off issues. The adjusted metric helps in assessing the sustainability of a company's earnings and its underlying Financial Performance over time.

Hypothetical Example

Consider Company A, which reported a net income of $50 million for the year. The company has 10 million shares outstanding, resulting in a GAAP Earnings Per Share of $5.00. The current share price is $100. This gives a standard P/E ratio of 20x.

However, upon reviewing the Financial Statements, an analyst discovers that the net income includes a one-time gain of $10 million from the sale of a non-core asset. This gain is not expected to recur. To calculate the Adjusted Price to Earnings, the analyst will remove this gain from the net income.

1. Original Net Income: $50,000,000
2. Less: One-time gain: $10,000,000
3. Adjusted Net Income: $40,000,000
4. Shares Outstanding: 10,000,000
5. Adjusted Earnings Per Share: $40,000,000 / 10,000,000 = $4.00
6. Current Share Price: $100.00
7. Adjusted Price to Earnings: $100.00 / $4.00 = 25x

In this hypothetical example, the Adjusted Price to Earnings (25x) is higher than the standard P/E (20x), indicating that the company's reported earnings were artificially boosted by a non-recurring event. This adjusted figure provides a more conservative and potentially more realistic measure of the company's valuation based on its ongoing earning power.

Practical Applications

Adjusted Price to Earnings finds numerous applications in Equity Valuation and investment analysis. Investors and analysts frequently use this ratio to standardize earnings for comparability across different periods or companies. For instance, when evaluating a company that has undergone a significant transformation or faced unique, non-recurring events, the adjusted price to earnings can provide a cleaner basis for assessment.

Companies themselves often present non-GAAP financial measures, including adjusted earnings, in their earnings releases and presentations to investor relations to highlight what they consider their "core" operating results⁵. These adjustments often exclude items such as Goodwill Impairment, large legal settlements, or the sale of business segments that are not part of ongoing operations. For example, some companies, like Teladoc Health, may adjust their EBITDA (a non-GAAP measure often related to earnings) by excluding items such as goodwill impairment and transformation charges to provide what they view as a clearer picture of their operational performance⁴. However, regulatory bodies like the SEC closely monitor these disclosures to ensure they are not misleading and are accompanied by proper reconciliation to GAAP measures³.

Limitations and Criticisms

Despite its utility, Adjusted Price to Earnings has several limitations and faces criticism. The primary concern revolves around the subjective nature of the adjustments. What one company or analyst considers "non-recurring" or "unusual" might be viewed differently by another. This lack of standardization can reduce comparability between companies, even those in the same industry, if they apply different adjustments.² The SEC staff, for example, has frequently commented on the appropriateness of adjustments, particularly those that eliminate what could be considered normal, recurring cash operating expenses, noting that such adjustments can render a non-GAAP measure misleading¹.

Another criticism is the potential for companies to "cherry-pick" adjustments that paint a more favorable picture of their financial health. While the intent of adjusted earnings is often to clarify core operations, some critics argue that it can obscure underlying issues by systematically removing negative items while retaining positive ones. Additionally, analysts must be cautious not to overlook the real cash impact of these "non-recurring" items, as even one-time charges or gains do affect a company's cash flow and overall Financial Performance. Investors should always examine the reconciliation of adjusted figures to their GAAP counterparts to understand the full scope of a company's financial activities.

Adjusted Price to Earnings vs. Price-to-Earnings (P/E) Ratio

The fundamental difference between Adjusted Price to Earnings and the traditional Price-to-Earnings (P/E) Ratio lies in the earnings figure used in the calculation.

Confusion often arises because both ratios serve as valuation multiples. However, their utility differs based on the context. The standard P/E provides a straightforward measure based on Generally Accepted Accounting Principles (GAAP). Adjusted Price to Earnings, on the other hand, attempts to provide a more insightful metric by isolating the recurring operational results, which can be particularly valuable when analyzing companies with volatile earnings due to infrequent events like large asset sales or significant Capital Expenditures.

FAQs

What types of items are typically adjusted out of earnings?

Common items adjusted out of earnings when calculating Adjusted Price to Earnings include one-time gains or losses from asset sales, Restructuring Charges, Goodwill Impairment, legal settlements, merger and acquisition-related costs, and other non-recurring, non-operating income or expenses. The goal is to isolate the earnings generated from the company's core business operations.

Why do companies report adjusted earnings if GAAP earnings already exist?

Companies report adjusted earnings, often referred to as Non-GAAP Measures, to provide investors with what they believe is a clearer picture of their underlying business performance, free from the noise of non-recurring or unusual events. The intent is to facilitate better year-over-year comparisons and to highlight sustainable profitability. Regulatory bodies, however, require these non-GAAP measures to be reconciled to their GAAP equivalents to ensure transparency.

Is Adjusted Price to Earnings a better metric than the standard P/E ratio?

Neither metric is universally "better"; they serve different purposes. The standard Price-to-Earnings (P/E) Ratio offers a consistent, GAAP-based view, but it can be distorted by one-time events. Adjusted Price to Earnings attempts to normalize these distortions, potentially offering a more accurate reflection of ongoing earning power for Valuation purposes. Investors should analyze both and understand the reasons for any adjustments to gain a comprehensive understanding of a company's Financial Performance.