Zooming in on Net Operating Income

[Share Investor]

by Investopedia Staff, (www.Investopedia.com)

Each and every earnings season, there are large-cap companies missing their estimated targets. On the day of the announcement a company's price can undergo inexplicable changes. In most cases, there are few substantive changes in a company, from a strategic and fundamental perspective. If small penny deviations in the EPS outcome can move the market for better or worse, then what long-run profitability measure can an astute investor count on? One possible answer lies in net operating income (NOI), a metric worth examining.

Defining Net Operating Income
Reports will often refer to NOI as NOPAT (net operating profit after taxes) or NOPLAT (net operating profit less adjusted taxes). Regardless of which acronym is used, the underlying concept is simple and expressed as follows:


NOI = operating income * (1-tax rate)


Earnings before interest and taxes (EBIT) is often used as a proxy for actual operating income, so NOI is therefore also defined as follows:


NOI = EBIT * (1-tax rate)


[Note: For the sake of simplicity, derive the tax rate as 35%, a rate that can be assumed to be applicable to most firms.]

Using NOI to Assess Companies
Although the firm's net income and subsequent earnings per share (EPS) constitute the much-hyped bottom-line, NOI is often as relevant and more reliable than net income for the following two reasons:

1. It Is More Difficult to Manipulate NOI
Generally accepted accounting principles (GAAP)of various governments make it clear which income and expenses flow into operating income: hence, NOI should not be creative. In other words, it is unwise for management to remove questionable expenses from the calculation of operating income if these expenses are part of recurring operations. It is equally unjustifiable to classify one-time income, such as special items and the sale of discontinued operations, as part of the calculation of operating income and NOI. Why? Poor accounting can be treacherous from both an investor-relations and a price perspective. This is especially true in the current economic environment, where the slightest hint of potential fraud can send any stock price into a tailspin.

Net income, on the other hand, can be altered considerably by below-the-line items such as changes in accounting principles, special items and sales of discontinued operations. Every firm is unique and should be analyzed with this tenet in mind. NOI, defined as an above-the-line item and calculated without one-time changes, is not prone to the potential effects of the isolated gains or losses that can significantly impact net income. Just as operating cash flow is often seen as a cleaner measure of a firm's overall strength, the trend and direction of net operating income can be viewed as an alternative to net income for the same reason: it's much harder to manipulate.

2. NOI Is a Key Measure in Stock Valuation and Asset Management
Why is NOI used in forecasting? Why is a strong track record of sustainable NOI growth often viewed as favorable? There is a second reason for calculating NOI. Without the influence of these potential below-the-line distortions, NOI is largely the measure used by investment management professionals to forecast not only the future trend in earnings but also the direction of the firm's free cash flow. The two forms of free cash flow, which are free cash flow to firm (FCFF) or free cash flow to equity (FCFE), dominate current valuation techniques of the large institutional interests and mutual funds. Both of these measures can be calculated by adding depreciation and subtracting both the firm's change in working capital and outflows related to capital spending. If the multi-billion-dollar pension and mutual funds are placing enormous long-term orders based on free-cash-flow-model techniques, then NOI, which is the root of both the FCFF and FCFE forecasting, is essential to this process of stock valuation.

Conclusion
In short, NOI is an informative and constructive alternative to net income. The media has a long-standing love affair with EPS. In many respects, this reporting makes sense, since earnings surprises can impact short-term prices and it is quite easy for a non-technical commentator to report whether or not a firm fell in line with EPS targets. This quarterly EPS focus is unlikely to change. In many countries such as Germany, quarterly reporting is largely non-existent and semi-annual reporting is the norm. It is nevertheless wise to look at how a firm's operating income and NOI performed in comparison with last year's figure and whether or not there is a positive or negative trend on the horizon.

Scrutinizing these two results a few lines above net income on the income statement may be not only relevant in terms of past operational performance, but also more meaningful for a future perspective. NOI and its reliability lie at the heart of widespread stock valuation techniques based on derived and forecasted free cash flows.

by Investopedia Staff

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