Monday, October 19, 2009

Evaluate Operating Performance: Net Operating Profit After Taxes

Although I'm partial towards the use of Operating Cash Flow (OCF) as a primary basis for performance measurement, investors should nonetheless be familiar with Net Operating Profit After Taxes (NOPAT). NOPAT is completely derived from the income statement, subjecting itself to the usual non-cash adjustments dictated by GAAP. However, NOPAT is useful because, as the name implies, it is strictly a measure of operating performance.

Calculation of NOPAT is relatively straightforward, you're simply multiplying Income From
Operations Before Taxes by the corporation's effective tax rate. To calculate the tax rate, divide income tax expense by net income before taxes(NIBT); make sure you place NIBT, also known as Pretax Income in the denominator, and not Operating Income. Once you've determined the total taxes owed, you just subtract it from Operating Income to arrive at NOPAT. The two step process is delineated below:

Tax Rate = Net Income Before Taxes / Income Tax Expense
Net Operating Profit After Taxes = Income From Operations Before Taxes X (1-Tax Rate)

*Note that a company's annual reports and 10-Q's will not always show a neatly constructed income
statement that spoon feeds you the Operating Income, Pretax Income, and Income Tax Expense lines. GAAP doesn't require the income statement to be constructed in any special sort of way, thus you may have to occasionally deploy some common sense. Nearly all of the time however, websites like Yahoo!Finance and (if you have a subscription) S&P's NetAdvantage will go ahead and break out the necessary line items. The point is, pay attention.

I'll use Hewlett-Packard Company (HPQ) to illustrate an example calculation of NOPAT:
HPQ NOPAT - Year Ended October 31st 2009
Tax Rate = $2144M / $10,473M
= 20.47%

Net Operating Profit After Taxes = $10,802M X (1-.2047)
= $10,802M X 0.7952

Hewlett-Packard's NOPAT of $8590M compares with net income of $8329M for fiscal year 2008; at only 3% less than NOPAT, 2008 net income is indicative of only a modest amount of interest expense for the year ($329M). The disparity between NOPAT and net income isn't always so m
inimal, as can be seen in the chart below:
General Electric (GE)'s large disparity between NOPAT and net income is an obvious first observation to make. The primary driver of this phenomenon is the $26,209M worth of interest expense incurred by the company during 2008. The second result of such a massive interest expense is that GE's 2008 effective tax rate was only 5.3% (interest is deductible). The relationship between these two variables will change based upon the industry, and circumstances specific to the company.

*long GE
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