This report is one of a series on the adjustments we make to convert GAAP data to economic earnings.

Reported earnings don’t tell the whole story of a company’s profits. They are based on accounting rules designed for debt investors, not equity investors, and are manipulated by companies to manage earnings. Only economic earnings provide a complete and unadulterated measure of profitability.

Converting GAAP data into economic earnings should be part of every investor’s diligence process. Performing detailed analysis of footnotes and the MD&A is part of fulfilling fiduciary responsibilities.

We’ve performed unrivaled due diligence on 5,500 10-Ks every year for the past decade.

Most adjustments we have discussed thus far can only be found by performing careful footnotes research, but some of the adjustments we make use items commonly found in a company’s financial statements. We tend to write more on the footnotes items because we find them more interesting. Nevertheless, quite a bit of work has to be done to clean up income statements as well.

Income statement adjustments include financing items like interest expense/income, preferred dividends and minority interest income. These items are related to the financing of a company’s operations, not the operations themselves. We always calculate NOPAT on an unlevered basis.

Other income statement adjustments include any unusual income or expense, such as a gain on sale or restructuring charge.

For instance, Yahoo (YHOO) earned $4.6 billion from selling its shares of Chinese e-vendor Alibaba and $44 million in interest, investment and other income. The $4.6 billion gain is offset by $236 million in restructuring charges, leaving $4.4 billion in income that the company classifies as non-operating but still includes in GAAP net income. We remove these non-recurring items for our NOPAT calculation to get a picture of the core profitability of the company.

Figure 1 shows the five companies with the largest positive and negative NOPAT adjustment for reported non-operating items in 2012.

Figure 1: Companies Most Affected By Reported Net Non Operating Items in 2012

Non-Op_Fig1Sources: New Constructs, LLC and company filings

These companies in Figure 1 are far from the only ones affected by reported non-operating items. In the last fiscal year, we removed 12,935 non-operating items. 2,134 companies had positive adjustments totaling over $454 billion and 422 companies had negative adjustments totaling nearly $39 billion. Going back to 1998, we’ve found 138,717 non-operating items with positive adjustments to companies totaling over $3.8 trillion and negative adjustments of $500 billion.

The removal of non-operating expenses can increase NOPAT and make a stock look undervalued. For example, Hewlett Packard (HPQ) had over $22 billion in reported non-operating expenses in 2012. These include $18 billion in write-downs (reported on the income statement rather than hidden in operating earnings), $2.3 billion in restructuring charges, $876 million in interest and other expenses, and $46 million in acquisition-related charges. HPQ reported GAAP earnings of -$12.7 billion for 2012, but removing these non-operating items helped bring its NOPAT to positive $7.6 billion. These adjustments drove our Attractive rating for HPQ, which is up 46% so far this year.

Due diligence in the financial footnotes is key, but its not enough for investors to scan the footnotes if they don’t know how to analyze the income statement. Adjusting out the non-operating items disclosed on the income statement gives a truer picture of a company’s profitability and can reveal when a company is over or under valued. Diligence pays.

Sam McBride and André Rouillard contributed to this report

Disclosure: David Trainer, Sam McBride and André Rouillard receive no compensation to write about any specific stock, sector, or theme.

    6 replies to "Reported Net Non-Operating Items – NOPAT Adjustment"

    • Donnell Q. Hubbard

      Gross income is sales price of goods or property, minus cost of the property sold, plus other income. It includes wages, interest, dividends, business income, rental income, and all other types of income. Adjusted gross income is gross income less deductions from a business or rental activity and 21 other specific items.

    • Kjell Rojvall

      Question about revenue recognition. Posted here due to the lack of a revenue section. How will you adjust for differences in company reporting in 2016 and 2017 as public companies adjust to FASB ASU 2014-09 Revenue from Contracts with Customers (Topic 606) issued May 28, 2014

      Full Retrospective Method; A company must restate 2016 and 2017 financials when publishing its 2018 financials, i.e. the company needs to determine the impact of the new standard on its 2016 and 2017 financial statements

      Cumulative Effect Approach; A company must determine the cumulative impact of the new standard in 2018 and book an adjustment to its 1/1/2018 retained earnings account.

    • Randall

      Why are non-operating items added back to NI in the case of Hewlett Packard but the non-operating expense is included in Yahoo? Especially the restructuring charges.
      Based on your examples:

      NI + writedowns + Restructuring costs = – $12.7 bil + $18 + $2.3 = $7.6 bil.


      Gain + interest and investment income – Restructuring = $4.6 bil. + $0.044 bil. – $0.236 bil = $4.408 bil.

      In HPQ the $2.3 restructuring amounts were added ( I say “add” for the sake of math, to keep the signs the same) to the gain back but in YHOO the $0.236 bil restructuring amounts were “subtracted” from NI.

    • Sam McBride

      In both cases, restructuring expense is being added back to earnings. The difference is that in the Yahoo example, the non-operating expense is offsetting $4.6 billion in non-operating income, so we subtracted the restructuring expense from the non-operating gain to calculate the net non-operating income. Apologies if those examples were confusingly worded.

    • Dan

      I understand the reasoning behind adding back (or at least not subtracting) restructuring charges to NOPAT. But why do you only add the after-tax asset write down part of the restructuring charges (excluding the severance costs) to invested capital? I’m referring to your DOW 2015 example.

    • Dan:
      Great question! The reason we only add back the after-tax portion of the write-off is that the tax benefit of the write-off expense is a real cash benefit to the company. The idea is that the net amount of capital that we add back should exclude the tax benefit realized from the expense. Note that even though we remove the expense and the related tax benefit from NOPAT, the expense does reduce GAAP pre-tax income and the related tax obligation of the company in the period the expense is reported. So, there is a real tax benefit realized by the company for taking the asset-write-down expense. And, we recognize that tac benefit by reducing the amount of capital added back for the write-off by the value of the tax benefit.

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