Core earnings

What Is Core Earnings?

Core earnings represent the profits generated from a company's primary, ongoing business operations, forming a crucial component of financial reporting. This metric aims to provide a clearer view of a company's sustainable profitability by excluding non-recurring, unusual, or extraordinary items that might distort the true picture of its underlying financial performance. Unlike net income, which is a generally accepted accounting principle (GAAP) measure, core earnings is a non-GAAP financial measure used by analysts and investors to assess a company's fundamental earning power. Core earnings helps stakeholders evaluate how efficiently a business generates profits from its core activities, offering insights into its operational health and future prospects.

History and Origin

The concept of core earnings gained significant traction following concerns that reported GAAP earnings could be obscured by one-time gains or losses, leading to a less clear understanding of a company's consistent operational profitability. In 2002, Standard & Poor's (S&P) introduced its own definition of "Core Earnings" to address these concerns, aiming to provide a more standardized measure of a company's ongoing profit from its central business.¹⁴ This initiative sought to improve the consistency of reported financial results and make earnings reports more comprehensible for analysts and investors. A key aspect of S&P's definition was the explicit inclusion of stock option grants as an expense, which was not always consistently treated in traditional GAAP reporting at the time.¹³ This focus on stripping out transitory items and including certain recurring expenses, such as stock-based compensation, aimed to present a more accurate and conservative measure of a company's financial health.

Key Takeaways

• Core earnings focus on a company's profits derived from its main, ongoing business activities, excluding one-time or unusual items.
• It is a non-GAAP financial measure, meaning it is not strictly defined by accounting standards like GAAP, but rather an adjusted metric.
• The primary purpose of evaluating core earnings is to provide a more consistent and reliable indicator of a company's sustainable profitability and operational efficiency.
• Analysts and investors often use core earnings for improved forecasting of future performance and for comparing companies within the same industry.
• While offering valuable insights, core earnings calculations can vary among companies and require careful scrutiny of the adjustments made.

Formula and Calculation

Core earnings are not derived from a single, universally mandated formula, but rather by adjusting a company's reported net income to exclude items considered non-core or non-recurring. The general approach involves starting with net income and then systematically adding back or subtracting specific items.

A simplified conceptual formula can be illustrated as:

These adjustments typically include, but are not limited to:

• Net Acquisition Expenses
• Net Currency Expenses (from unusual fluctuations)
• Net Discontinued Operations Expenses
• Net Legal or Regulatory Expenses (one-time large settlements)
• Net Pension Adjustments (non-operating gains/losses)
• Net Restructuring Expenses
• Gains or losses from the sale of assets
• Impairment charges, such as goodwill impairment

For example, an academic paper identifying key components to exclude from GAAP earnings to arrive at core earnings includes items like acquisition expenses, currency fluctuations, discontinued operations, and restructuring costs.¹¹, ¹² When companies present non-GAAP financial measures like core earnings, they are generally required by regulatory bodies, such as the Securities and Exchange Commission (SEC), to provide a reconciliation to the most directly comparable GAAP measure, typically net income.⁹, ¹⁰ This reconciliation helps users understand the specific adjustments made.

Interpreting the Core Earnings

Interpreting core earnings involves looking beyond a company's reported net income to understand the quality and sustainability of its profits. A higher core earnings figure, especially one that shows consistent growth over time, suggests robust operations and effective management of the primary business. Analysts use core earnings to gain a clearer picture of a company's underlying financial performance, free from the "noise" of extraordinary or non-recurring events.

For instance, if a company reports a significant net income boost due to the sale of a property, its core earnings would exclude this one-time gain, providing a more accurate reflection of its profitability from ongoing sales and services. This distinction is vital for accurate valuation analysis and for making informed investment decisions. By focusing on core earnings, investors can better compare the operational efficiency of different companies, even if their GAAP financial statements are affected by disparate non-recurring events.

Hypothetical Example

Consider "Tech Innovations Inc.," a software development company. In the fiscal year 2024, Tech Innovations Inc. reported a net income of $50 million. However, during that year, the company also incurred a $10 million one-time restructuring charge related to closing a non-core division and recorded a $5 million gain from the sale of an old office building.

To calculate its core earnings, an analyst would adjust the reported net income:

1. Start with Net Income: $50 million
2. Add back the restructuring charge: This is a one-time expense not related to core operations.
   $50 million + $10 million = $60 million
3. Subtract the gain from the sale of the building: This is a one-time gain from an asset sale, not core business revenue.
   $60 million - $5 million = $55 million

Therefore, Tech Innovations Inc.'s core earnings for 2024 would be $55 million. This figure provides a more insightful view of the company's profitability from its continuous software development business, excluding the temporary impacts of the restructuring and asset sale. An investor looking at this would have a clearer understanding of the company's true earnings capacity, allowing for a better assessment of future earnings per share.

Practical Applications

Core earnings are widely utilized in various real-world financial contexts, primarily for enhancing the accuracy of financial analysis and investment decisions. For investors, core earnings help in assessing a company's true earning power and its ability to generate sustainable profits. This is particularly useful in industries where companies frequently experience unusual charges or gains, such as those undergoing significant merger and acquisition activity or frequent restructuring.

Financial analysts often rely on core earnings to create more reliable financial models and earnings forecasts. By stripping out transient items, they can better predict future profitability and calculate more representative financial ratios, such as the price-to-earnings ratio. Regulatory bodies, like the SEC, monitor the use of non-GAAP measures, including core earnings, to ensure that companies do not mislead investors. The SEC provides guidance to ensure that if non-GAAP measures are presented, they are clearly explained and reconciled to their GAAP counterparts, and that the GAAP measure is given equal or greater prominence.⁸ This regulatory oversight underscores the importance and potential impact of adjusted figures in corporate financial reporting.

Limitations and Criticisms

While core earnings offer a valuable perspective on a company's operational profitability, they are not without limitations and criticisms. A primary concern stems from their nature as non-GAAP financial measures, which means there is no universally standardized definition or calculation methodology. Companies have discretion in determining which items to exclude or include, potentially leading to a lack of comparability across different firms or even across reporting periods for the same company. This flexibility can introduce bias, as companies might selectively exclude recurring cash operating expenses to present a more favorable financial performance.⁶, ⁷

For example, some companies might omit stock-based compensation expenses from their adjusted earnings, despite these being a real cost of doing business.⁵ Critics argue that this can overstate reality, creating a significant divergence between reported GAAP earnings and adjusted figures. In 2015, for instance, reported S&P 500 earnings were substantially lower than adjusted earnings.⁴ This divergence can be particularly problematic when a company faces financial difficulties, leading to increased scrutiny of its adjustments by investors and regulators.², ³ Analysts emphasize the importance of exercising a critical lens when evaluating adjusted earnings, advocating for a thorough examination of the specific adjustments made and their underlying rationale to ensure the quality of earnings.¹

Core Earnings vs. Adjusted Earnings

While closely related, "core earnings" and "adjusted earnings" are distinct in their typical usage and intent.

Adjusted earnings is a broader term for any financial metric derived from GAAP earnings by adding or subtracting items to present an alternative view of financial performance. Companies often disclose adjusted earnings figures in their financial reports or earnings releases to highlight performance excluding items they deem non-recurring, unusual, or outside their normal course of business. These adjustments can include a wide range of items, such as restructuring charges, asset write-downs, or gains from divestitures. The specific items adjusted can vary significantly from one company to another, making direct comparisons challenging without careful scrutiny.

Core earnings, on the other hand, is a more specific concept focused strictly on the profits generated from a company's central, ongoing business activities. While it is a type of adjusted earnings, core earnings specifically aims to strip away all transitory shocks and earnings from ancillary activities to provide a consistent and persistent measure of true operational profitability. For instance, Standard & Poor's defined its own "Core Earnings" metric with specific inclusions and exclusions to standardize this view for companies in its equity indexes, aiming for a more conservative measure than broader adjusted earnings. The key difference lies in the intent: adjusted earnings are often company-specific presentations, while core earnings strives for a more standardized, analyst-driven view of a company's sustainable core operations.

FAQs

What is the main purpose of calculating core earnings?

The main purpose of calculating core earnings is to get a clearer, more consistent picture of a company's true profitability from its primary business operations. It helps eliminate the "noise" from one-time or unusual events that can distort reported net income.

Is core earnings a GAAP measure?

No, core earnings is not a GAAP (Generally Accepted Accounting Principles) measure. It is a non-GAAP financial measure, meaning it's an alternative calculation that companies or analysts create by adjusting GAAP figures. Companies must reconcile non-GAAP measures to their GAAP equivalents when reported.

Why do companies report core earnings if it's not GAAP?

Companies often report core earnings (or similar adjusted earnings) to provide investors and analysts with what they believe is a more representative view of their ongoing operational performance. It helps in assessing the sustainability of profits and making better comparisons across periods or with competitors.

What types of items are typically excluded from net income to arrive at core earnings?

Items typically excluded from net income to arrive at core earnings include non-recurring expenses or gains, such as restructuring charges, asset impairment losses, gains or losses from selling non-core assets, legal settlements, and certain unusual currency fluctuations. The goal is to isolate profits from the core business.

How does core earnings help investors?

Core earnings helps investors by providing a more reliable basis for forecasting future earnings and assessing a company's underlying financial health. By focusing on recurring profits, investors can make more informed decisions about a company's valuation and its potential for consistent earnings growth.