By David Harper, (Contributing Editor - Investopedia Advisor)
In finding economic profit, the essential step is to calculate net operating profit after taxes (NOPAT), and this chapter looks at how to do it. We get to NOPAT by translating - through a series of adjustments - an accrual-based income statement number into a cash-based profit number. Although there are three basic steps in the process of finding NOPAT, there is no single correct method for arriving at a final number.
The method an investor uses is a matter of how approximate or precise he or she wants to be. Some critics lament that economic profit requires 50-150 adjustments - but many users of economic profit agree that most of the answer is found after a dozen or even fewer adjustments. In fact, beyond a handful of adjustments, you are really only fine-tuning the NOPAT number. And, from an investor's standpoint, a multitude of adjustments simply are not necessary. In using economic profit, the investor's priority is consistency and comparability. In other words, calculating economic profit with 99.9% precision is less important than ensuring the method of calculation is consistent from year to year and from peer to peer.
The Stages of the Process
Getting to NOPAT takes three basic steps:
- Start with earnings before interest and taxes (EBIT).
- Make the key adjustments - these come in two flavors:
- Subtract cash operating taxes.
1. Start with EBIT (Or Something Close to It)
Throughout this tutorial, we build a 2004 economic profit calculation for the Walt Disney Company (DIS). Its latest financials are available in the company's 2004 10-K filing (the annual report), and below are selected lines from the income statement.
Figure 1 (numbers are in millions)
For better or worse, GAAP does not mandate any one particular presentation of the income statement, so we need to pay careful attention to the line items. Disney does not disclose EBIT on the income statement, so the first step in the economic profit calculation requires some work. Instead of reporting EBIT, Disney shows 'income before income taxes & minority interests', which is an after (net) interest-expense number.
Therefore, our first important adjustment is to add interest expense back, or to "move it above" the interest expense, so to speak. With this adjustment, we ensure, as discussed in chapter 2, that our NOPAT number is not reduced by interest paid and is thereby deleveraged: we want a number that captures the profits that accrue to all capital holders including lenders.
Before moving on to step 2, we provide in Figure 2 below an illustrated summary of the entire calculation that gets us from the line reporting 'income before income taxes & minority interests' on Disney's income statement to NOPAT. In working through the remainder of the three-step process, we'll break this summary down and examine the underlying calculations.
Figure 2 - (numbers are in millions)
2. Make the Key Adjustments: Translate Accrual to Cash, and Capitalize Investments
In chapter 2 we explain that adjusting EBIT is twofold and involves (1) converting accrual-based EBIT to a cash-based profit number and (2) capitalizing expenses that ought to be treated as investments. 'To capitalize' is to move an expense to the balance sheet and treat it as a long-term asset instead of a short-term expense - although, here we broaden the term to refer to any adjustment that moves an expense to the balance sheet, becoming either debt or equity.
Finally, as we move through step 2 of the NOPAT calculation, keep in mind that a capitalizing adjustment changes NOPAT and invested capital (will be discussed in chapter 4 where we consider balance sheet changes). The process of capitalizing an expense is a two-way mirror: we must match an income statement adjustment with a balance sheet adjustment.
As you can see from Figure 2, our key adjustments (step 2) together culminate into an addition of $781 million to EBIT, which gives us net operating profit (NOP). From NOP we subtract cash operating taxes (step 3) to achieve NOPAT.
Now, here is the breakdown of the key adjustments (step 2):
Figure 3 (numbers are in millions)
The adjustment related to LIFO reserve is relevant only to those companies who use LIFO inventory accounting. Disney does not use LIFO, so no adjustment is required here, but it is worth noting the importance of the step for those companies that do use LIFO. If the price of these companies' inventory is rising, then cost of goods sold (COGS) is pushed up because under LIFO, COGS reflects the cost of the recently purchased, more expensive inventory. Adding the increase in the LIFO reserve (as indicated in Figure 3) converts the cost of goods to what it would be under FIFO accounting, which is closer to actual cash flows.
The allowance for bad debt is sometimes very revealing. An increase in this account is not a reduction in (loss of) cash; it reflects a decision to acknowledge additional expenses in anticipation of future cash losses (i.e. a portion of receivables that are not collected). Because its increase represents a paper reduction in profits (not an actual reduction in cash), we add it back to get to the cash-based NOPAT.
In Disney's case, however, we made a reduction of $21 million. Why? Because instead of experiencing an increase, the account decreased over the period, and, a decrease in the allowance for bad debts should be subtracted (just as an increase should be added). In lowering this allowance, management is creating a paper gain, boosting the calculation of profits! But since this boost is not actual cash, we subtract it ("reverse it out") to get closer to the cash-based number.
The 'implied interest on operating lease' is probably the most difficult key adjustment to understand, but if you take the time to grasp the rationale for this adjustment, you'll be well on your way to understanding economic profit. Before studying the adjustment's calculation, we should establish that economic profit translates the operating lease into a capital lease - because economically the two leases are similar (even though they are accounted for differently).
A company gets to treat operating leases as expenses, so, unlike the treatment of capital leases, accounting for operating leases places no liability on the balance sheet. But operating leases are a type of off-balance-sheet financing, so they need to be put back on the balance sheet. This will treat the operating lease like an asset that is funded with a debt-like obligation. But, as this movement to the balance sheet takes place, NOPAT must be credited for the financing component of the lease expense for the same reason that we added back interest expense to 'income before income taxes & minority interests' in step 1.
There are a few ways to get an estimate for the implied interest on an operating lease. Scientific precision is not necessary (unless perhaps you are dealing with a company with a large portion of assets, such as some retail firms). All companies must disclose their future stream of minimum obligations under operating leases, so this disclosure of future obligations - after the obligations are discounted - serves as an estimate of the present value of the obligation. This process is very much like solving the present value of a bond obligation for which we know the cash flows and the interest rate:
Figure 4 (numbers are in millions)
In our example above, we used a discount rate of 6.76% to convert the reported future obligations into a single present value of $11, 866 million. (Note: this is going to be the debt equivalent that we put back onto the balance sheet in our discussion in chapter 4). As explained in the footnote above, this illustration of PV uses a precise method - the implied interest rate is borrowed from the company's disclosure of its capital lease obligations, but we could also have plugged in our own reasonable estimate.
3. Deduct Cash Operating Taxes
The final step in finding NOPAT is to subtract cash operating taxes (the taxes that a company actually pays with cash) from net operating profits. Truth be told, we could use reported taxes and we would still have a viable economic profit number (although purists would cringe at such a practice). But because in financial reporting, the tax books are separate from the financial statements, the amount that companies pay in taxes may be different than the amount they record as a tax expense. The point in using cash taxes is to capture a true cash return generated from the actual cash investment: what if for some reason our company pays abnormally low taxes in the reported year? Subtracting an estimate of cash operating taxes ensures the NOPAT number isn't "fooled" by reported taxes.
Figure 5 (numbers are in millions)
In Figure 5 above we show the underlying calculation for the $1,552 million subtracted in Figure 2. First the increase in deferred tax liability is added to the income-tax expense reported on the income statement (the word "expense" connotes "income-statement item"). The difference between the expense and actual taxes paid is slotted into deferred tax liability, as if it were going to be paid in the future. The deferred tax liability therefore increases when companies pay less in cash taxes than they record on their balance sheet. Because the increase is paper, we subtract it to get closer to actual cash taxes paid.
The addition of the tax subsidy on deductible expenses relates to a principle that should by now be familiar: we want a number that captures tax expenses before accounting for obligations to both debt and equity holders. The expenses listed on the income statement that are "above" pretax income (the deductible non-operating expenses) get the benefit of a tax shield: they reduce the reported taxable income and therefore the income-tax expense. These effects are reversed by the addition of the tax subsidy on deductible expenses [total tax-deductible non-operating expenses x tax rate (%)] to the reported income-tax expense.
After we do this, getting our final number, we see that cash operating taxes are higher than reported taxes.
Although this section drills down on the operating lease and cash operating tax calculations, here's a summary of the general calculation of NOPAT that we demonstrate: start with EBIT, make a set of key adjustments to EBIT and then, to get to NOPAT, subtract an estimate of cash operating taxes that would have been paid under NOP.
Keep in mind this is not a comprehensive set of potential adjustments (at the end of this tutorial we will show a longer list) but, as long as consistency is maintained when invested capital is calculated, the process shown here is a perfectly reasonable economic profit calculation.
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