It is more beneficial to use net operating profit after tax, or NOPAT, as opposed to net income when making an investment decision because a company's NOPAT is a measure of profit that excludes the cost and tax benefits of debt financing in that company's capital structure.
What Is Net Operating Profit After Tax?
NOPAT is essentially a company's earnings before interest and taxes, or EBIT, adjusted for the impact of tax structure. The equation for NOPAT is as follows:
Net Operating Profit After Tax=(i)×(1−r)where:i=Operating Incomer=Tax Rate
Why Is a Company's Net Operating Profit After Tax More Important to an Investor Than Its Net Income?
Since NOPAT does not take into account debt and the associated interest payments, it gives investors and analysts a better picture of a company's operational efficiencies. This calculation is not overshadowed by how a company decides to leverage itself or by the amount of its bank loan.
Since interest payments are a pretax expense, the formula subtracts from a company's earnings before taxes, therefore reducing the overall net profit of a company but also reducing the tax liability owed by that company. When using NOPAT instead of net income to assess the operations and profitability of a company, an investor is able to get a much clearer picture of how the company operates.
If, for example, a company has $100 of NOPAT but also has a $100 monthly interest payment, it looks unprofitable to an investor. It is possible, however, that the company could be actively paying down its debt or plans to take on an interest payment of this amount, meaning the operations might be fine, and thus worth a long-term investment.