When deciding whether to invest in a company, there are a variety of different metrics you can use. Those can include net income, earnings before interest, taxes, depreciation and amortization (EBITDA) or adjusted earnings. All of these are used to gauge a company’s financial health, just in different ways. If you’re reviewing adjusted earnings for a company, it’s important to understand what this measures and how to use it as a guideline when making decisions in your portfolio. If you want hands-on help evaluating whether an investment is a smart decision for you, consider enlisting the help of a professional financial advisor.
Adjusted Earnings, Definition
To understand adjusted earnings, it’s first helpful to have a little background information on how companies manage their accounting practices. Generally accepted accounting principles, or GAAP, refer to a set of standards and guidelines that are used by publicly-traded companies to produce financial reports. In other words, GAAP is more or less a uniform accounting code that companies follow when reporting things like earnings and profit and loss.
Non-GAAP reporting is an alternative way to track a company’s financial performance. Adjusted earnings is a non-GAAP reporting metric that allows companies to make adjustments to earnings by factoring in large one-time expenses or losses that would ordinarily not be considered part of the operating status quo. For example, if a corporation goes through a large-scale restructuring those costs could be used to adjust earnings for the year.
Why Companies Use Adjusted Earnings
As mentioned, there are different ways companies can measure and report financial performance. Net income, for example, is the measure of sales minus the cost of goods sold, as well as other expenses, such as operating costs, depreciation and taxes. This number can tell you how wide the gap is between a company’s revenue and its expenses and whether it’s spending more than it earns.
EBITDA can be used as an alternative to net income. This metric essentially tells you how profitable a company is and how well it has performed over a certain time period. EBITDA can be used to make apples-to-apples comparisons between companies in the same industry or sector.
Adjusted earnings are something companies may use when they incur a large expense or experience significant one-time gains that wouldn’t otherwise be part of regular operating expenses. By using an adjusted earnings figure to offset those expenses or gains, the idea is that the company can generate a more accurate picture of its financial health.
This is something companies may choose to do if they’re hoping to attract attention from investors to raise capital or if they’re seeking debt financing through a bank or another lender. An adjusted earnings figure that excludes sizable one-time costs can make the business’s bottom line look better, which may sway investors to buy shares or banks to lend money.
Why Adjusted Earnings Can Be Problematic for Investors
While there are some benefits to publishing adjusted earnings for companies, there are some potential pitfalls for investors. The biggest disadvantage is that because adjusted earnings are a non-GAAP measure, it can be very easy for companies to manipulate these reports to exclude costs that shouldn’t be excluded. For example, in addition to one-off expenses, companies might omit basic everyday operating expenses to make a company look better on paper.
What happens there is that an investor may only look at adjusted earnings to gauge financial performance. If adjusted earnings look good, they may invest only to find out that those figures weren’t exactly accurate when the company runs into financial trouble.
On the other side of the coin, companies can also use adjusted earnings to highlight one-time earnings boosts while leaving out temporary costs. Again, this is problematic because an investor may buy shares expecting that earnings trend to continue only to be disappointed when the company’s performance returns to normal.
How to Evaluate a Company Using Adjusted Earnings
When using adjusted earnings to compare companies as an investor, it’s important to look closely at what the company is reporting with regard to earnings and expenses. Specifically, it’s important not to focus on just one-time expenses or gains. Also, look to make sure the company is accurately reporting its everyday operating expenses. If there is a large one-time expense or gain look at what the reason for that was and how it may affect short- and long-term profitability.
Also, consider how adjusted earnings have trended over time. For example, have adjusted earnings been on a steady upward trajectory, or do the numbers spike up and down? And if a company is reporting adjusted earnings for the first time, ask yourself why that is.
Finally, take a look at other financial ratios to get a better sense of what’s happening with a company financially. For example, the earnings per share measure the net income earned on individual shares of common stock in a company. When earnings per share is zero or negative, that means the company has zero or negative earnings.
Price-to-earnings ratio represents the share price of a company’s stock divided by earnings per share. This number can be used to gauge how much you could potentially earn by purchasing shares of stock in a particular company. Other ratios to consider include the debt-to-equity ratio, current ratio, quick ratio and net profit margin.
Bottom Line
Adjusted earnings can offer insight into a company’s financial outlook, but it’s important to consider where those numbers are coming from and how accurate they are. Using adjusted earnings, alongside net income, EBITDA and other financial ratios can be a helpful way to evaluate a company’s finances. The more information you have on a company’s financials, the easier it can be to make an informed decision about whether to invest.
Tips for Investing
- Consider talking to a financial advisor about what adjusted earnings means and how to decode it when reviewing investments. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- When comparing investments, consider whether it makes more sense to use a fundamental or technical approach. Fundamental analysis involves digging into a company’s fundamentals, i.e. exploring its financial statements to determine its underlying value. Technical analysis, on the other hand, is more concerned with stock price movements and how those are affected by current and near-term trends. Understanding how the two differ and how they can be used together can help you fine-tune your investment strategy.
Photo credit: ©iStock.com/FG Trade, ©iStock.com/g-stockstudio, ©iStock.com/bigtunaonline