In this tutorial, speaker David Trainer explains why Net Operating Profit After Tax (NOPAT) is the essential numerator for Return on Invested Capital (ROIC) and details the extensive adjustments his firm makes to derive a true operating cash profit figure. He emphasizes the scale of his operation—processing over 70,000 annual reports dating back to 1998 with proprietary technology—to uncover hidden items that distort net income. The core adjustments include stripping out asset write‑downs hidden in operating expenses, non‑operating items such as foreign‑exchange losses and litigation settlements, changes in reserves, discontinued operations, implied interest on off‑balance‑sheet debt, and non‑operating taxes. He also still accounts for historical goodwill amortization and pre‑2006 employee stock‑option expenses. Trainer illustrates the material impact of these adjustments with real‑world examples (LifeLock, Hess Corp, Olin Corp) where reported net income diverges dramatically from adjusted NOPAT. The overarching message is that investors need to perform these deep‑dive adjustments—available in his “30+ Adjustments” blog post—to see the true recurring operating profitability and level the playing field with Wall Street insiders.
Chapters
Net operating profit after tax is the key metric in the numerator for the return on invested capital calculation. In another tutorial, I talk about ROIC and how important that is. I also talk about data quality. And in this tutorial on net operating profit after tax, I'm gonna go into some more details. I'm gonna give you specifics on the adjustments we make. And by the way, anytime you want to get more details on these specifics, See my blog post, 30+ Adjustments to Get the Truth About Earnings Quality and Valuation. There's all the detail you want there. But specifically, net operating profit after tax. A lot of people talk about it. No one does it as well as we do. No one does it as well as we do with anywhere close to the scale we do it. Now, there might be some guy in his basement living with his parents. He's got 6 months to work on a model. He might come up with one company, maybe 2, with a NOPAT metric that's as accurate as ours because he's got that kind of time. And it takes that much time because annual reports are over 200 pages long on average, some are close to 2,000 pages. And you gotta go through every single page if you wanna make sure your notepad's correct. And we do that. We do it because we've got technology and experience. We've been through over 70,000 annual reports dating back to 1998. Nobody knows where the bodies are buried better than we do, and no one's been able to build technology as smart as we have because we've seen more. than everyone else has, and our system has churned through and processed more than anyone else has. So let's get to some of these adjustments. One of the top adjustments we make is removing asset write-downs hidden in operating expenses. This is often something you only find in the MD&A, where you'll find that there's actually some sort of write-down or charge for inventory obsolescence, loss on the sale or disposal, or whatever. And it's baked into the cost of sales, or it's baked into SG&A, or sometimes baked into depreciation. You never know, but you'd never know it was there until you looked in the MD&A, the footnotes. That's one of our big adjustments to NOPAT. Another one we make is non-operating expenses, net non-operating expenses, hidden operating items. A good example of this is foreign currency exchange losses, right? Sometimes companies will break that out on the income statement, a lot of times they won't. A lot of times there's unusual gains. A lot of times there's a litigation settlement and you never know about it by looking at the income statement because they only talk about it in the footnotes or the MD&A. There's also the change in reserves. That makes a big deal. A lot of times companies are providing a provision or an inventory reserve and you'll see on the balance sheet that there are big changes in these items, but it's not reflected in the income statement because the company wants to smooth it through. Or oftentimes they'll say, oh, well, our loss provision can be lower for loans or other items. And all they're doing is depleting reserves. So they're basically able to lower their expenses, improve income by taking money out of reserves. And if you don't look at the change in reserves to adjust what the provision is, well then you don't understand cash flows. Discontinued operations can be a big source for unusual items that are disrupting the truthfulness of net income relative to NOPAT. Then there's the implied interest relative to off-balance sheet debt. If you're going to convert all that off-balance sheet debt back to on-balance sheet, you've got to look at the implied interest related to that that's not on the income statement. Non-operating taxes is a huge one. For example, LifeLock, one of the companies in a more recent fiscal year, Huge difference between net income and NOPAT. They report $54 million in net income and only $19 million in NOPAT. Most of that's because of taxes. Now let me tell you, I've been looking at how to calculate cash operating taxes for over 10 years, maybe 15, and it's virtually impossible to do in the original method, the indirect method, where you start with the income tax provision and work back to cash operating taxes. You can't do that anymore because there are too many funky things going on. And the deferred tax asset, deferred tax liability, and the valuation allowance with respect to taxes. So we've had to come up with a very sophisticated approach to getting to the truth, and a lot of that is based on looking at the actual pre-tax and after-tax values of charges that we find buried in the footnotes in the MD&A. And that's where we actually find the true effective tax rate, and we use that as a way to get through to the real cash taxes the company's paying. And in a lot of cases, it's very different from what they report on the income statement, and it makes a big difference to understand cash flows. Some of the things that we don't do as much anymore because rules have changed, but we still do because we wanna make sure our models are correct all the way back to 1998: goodwill amortization, employee stock option expenses prior to 2006. We found companies, you know, before FASB finally decided to make stock option expense a real expense, companies were taking advantage of that loophole like crazy. There were companies like Siebel and VeriSign and a few others, and I'm having to go straight from memory here, where the option expenses were 40, 50, 100% of revenue when you actually looked at what the real cost was. But they didn't have to report that because FASB said they didn't have to. That was a major improvement that FASB made when they actually said companies should report their option expenses. There are other non-operating items. Often many of these can be found on the income statement, but you've got to pull out the non-operating items in order to get to the net operating profit after tax. Let's be specific. Net operating profit after tax, that's the cash flows that the business is really making, okay? So net income can be disrupted and disjointed by all these non-operating and unusual items. We don't want that. We want to get to what? Something that is the best proxy possible for the recurring operating profits of the business. That's what NOPAT is supposed to be about, and that's why you're gonna make these adjustments. A couple of companies, other companies where there's been a big difference: HesCorp, ticker HES. They had, they showed net income of $5 billion, and we showed NOPAT of just $1.9 billion. A big part of that is an unusual gain and changes in reserves. So 2 different adjustments make a difference there. Another one that we— that where there's a big difference was Olin Corporation, ticker OLN. Those guys had a big bunch, a big chunk of unusual income that we only found in the MD&A that was boosting their net income even though their net operating profit after tax was much lower. So I think it's important to underestimate. I'm not trying to do scare tactics here with a bunch of adjustments. I'm trying to shoot straight with investors about how much work it takes To get to the truth. And I'll back my sayings up and what I'm doing here with real data. Go to the website, go to the blog and see the 30+ adjustments and you'll see examples where every single adjustment we talk about, there is a material impact on at least 5 or 10 companies. We'll show it to you. We're not just trying to do scare tactics here, we're just trying to give investors an opportunity to be on even footing with the big Wall Street insiders who have access to this data easily, who oftentimes are creating the accounting loopholes themselves or finding ways to, to exploit the gray areas in accounting to overstate earnings to do more deals. That's what it's like. I was on Wall Street, I've seen how the sausage is made, and I'm helping investors get to the truth.
