Beyond the Jargon: It’s all about Earnings
Net profit after tax (NPAT), adjusted earnings, normalised earnings, pro-forma earnings, earnings per share… With so many different phrases and versions, it’s no wonder some investors struggle to stay on top of it all. In this third edition of Beyond the Jargon, I’ll explain what these differing terms mean, what some of the pitfalls can be, and share a few tips for assessing the quality of a company’s earnings.
Alternative terms: Earnings, profit, net profit, NPAT, the bottom line.
Short explanation: Earnings is simply an accounting term for what’s left over from revenues after everything else has been deducted. As it’s subject to accounting rules, it may or may not reflect the true cash generated by the business.
Detailed explanation: As mentioned in the short explanation, “earnings” is an accounting term, which means it is subject to accounting rules. Accounting rules are written by accountants, not investors, so are not designed to reflect the true economics of a business. As an example, if you turn to the Notes to the Financial Statements of any listed company you’ll find Significant Accounting Policies, (which can be great to read if you’re struggling to get to sleep) these should give you an idea of how a company recognises revenues.
Once you’ve navigated the minefield of standard accounting practices, the next thing to contend with is the company’s “adjustments”. While these can sometimes be entirely legitimate, generally, the more adjustments you see, the less you should trust the end figure. There are far too many different types of adjustments to discuss them all here, but reading management’s comments on the reasons for the adjustments and applying your own judgement as to the legitimacy is a good place to start.
Normalisation is generally used when a company’s earnings are subject to equity or bond market fluctuations, such as an insurance or annuity company. As market fluctuations are out of management’s control, these are often removed to better reflect the performance of the underlying business. Of course, market fluctuations of any investments held affect the value of a company, so they cannot be ignored altogether.
“Pro-forma earnings” are projected earnings, usually in the form of a prospectus. When a company is looking to list publicly, it must prepare a set of projected earnings for the period ahead – these are the pro-forma earnings.
One simple way of checking the quality of a company’s reported earnings is by comparing earnings to cash flows. Over time, Operating Cash Flow should be roughly equal to earnings after subtracting interest earnings/expense, depreciation, and amortisation - these are subtracted as the matching entries in the cash flow statement fall under different sections.
Finally, you might be asking “why are earnings per share growth sometimes different from earnings growth?” Simply, this is because the number of shares on issue often changes throughout the year. This can be due to buy backs, a capital raising, conversion of options, employee/director share plans, or dividend reinvestment plans. Properly calculating earnings per share is a surprisingly detailed task that gives rise to the worst acronym ever conceived – EFPOWANOS (equivalent fully paid ordinary weighted average number of shares). As I aim to inform rather than bore my readers, I won’t be explaining EFPOWANOS further.