Net Operating Profit After Tax (NOPAT)

What is NOPAT?

NOPAT stands for net or normalized operating profit after tax and represents the after-tax, pre-financing profits of a business. It can also be viewed as the “unlevered net income” as it is the amount of net income the business would have earned if it had no interest expense. In other words, the measure represents the amount of earnings which are available to all financing providers of the firm.

The measure is widely used in both credit and valuation analysis and is an essential step when calculating a firm’s available free cash flows. This cash flow is used to assess the debt capacity of a business or value it in a discounted cash flow analysis.

Key Learning Points

• NOPAT is the net income available to all financing providers of the company if it had no interest expense
• It is an important step to calculate a company’s available free cash flows, which is widely used in a discounted cash flow analysis (valuation) and debt capacity analysis (credit)
• The long term effective tax rate should always be used to tax adjust the earnings figure. This represents the tax rate observed in the income statement and is calculated as reported tax expense divided by profit before tax
• NOPAT is a preferred measure of operational efficiency for leveraged companies as it negates the impact of interest payments. Lower reported net income figures can be as a result of high-interest expenses rather than poor performance and NOPAT provides a better indicator of operational performance in this scenario.

NOPAT Formula

NOPAT is calculated using the following formula:

= (Revenues – Operating expenses) * (1 – Long term effective tax rate)

Revenues minus operating expenses provide the earnings before interest and taxes for the period. In most cases, EBIT is equal to the reported operating profit. Reported operating profit should be adjusted for any non-recurring items such as one-off restructuring or impairments to provide a better insight of the underlying profitability of the businesses’ operations.

The long-term effective tax rate should always be used when tax adjusting the earnings. The effective tax rate is the rate observed in the income statement of a company. It represents the average tax rate applied to the company’s total earnings for the earnings period.

In some cases, in may be beneficial to calculate NOPAT starting at the bottom of the income statement. Here, it is calculated using the following formula:

NOPAT = (Net income + Interest expense + Tax expense) * (1 – Long term effective tax rate)

This yields the same result; the only difference is the presentation of the calculation. The calculation starts at net income (which needs to be adjusted for after-tax non-recurring items), which is the profit available to shareholders after all expenses. The interest and tax expense for the period are added back. This provides the operating profit or EBIT.

This operating figure is now adjusting for the long-term tax rate to calculate NOPAT for the period.

Example Calculation

We have been provided with the following information about a company (shown below). We want to calculate the NOPAT for years 0 to 3.

We start at the reported revenue or sales figure. This is the total income generated from sales within a particular period and is the underlying driver of profitability for a business. We then deduct the operating expenses from the revenue to calculate the operating profit or earnings before interest and taxes (EBIT).

Next, we tax-adjust EBIT, because tax expenses are paid to the government and are not available to the providers of finance. This adjustment gives us NOPAT or the tax-adjusted operating profitability of the business.

Applications of NOPAT

NOPAT is used to calculate the free cash flow of a business which represent the cash flows generated by the core operations of the business that are available to all capital providers. This analysis identifies the cash flows available to service debt and determines the value of a company in a discounted cash flow analysis.

Discounted Cash Flow Analysis

NOPAT plays a vital role in the discounted cash (DCF) analysis valuation method. The first step of DCF analysis involves forecasting the free cash flow to be discounted. These cash flows are generated by the operational business and are available to all providers of finance. Several steps are involved in “freeing” up the business’ cash flows from the effects of financing and calculate what’s available for both the equity and finance providers.

Another use of NOPAT in the DCF analysis is the calculation of the cash conversion ratio. Its formula is free cash flow/NOPAT. The cash conversion ratio should be higher in steady state as the investment requirements reduce at this stage.

Determining the Debt Servicing Capacity of a Business

In a leveraged buyout (LBO), the ability to borrow is one of the key drivers of return and financing capacity for private equity investors. Cash flow-based debt capacity is one methodology to determine the amount of debt a company can safely support.

Return on Invested Capital (ROIC)

NOPAT is used in the analysis of ROIC and provides a metric to assess how efficiently and profitably companies have managed their operations.

The ratio is calculated as NOPAT/average invested capital with invested capital reflecting the book value of all operating assets. Whilst this is an accounting return, many companies use this measure to assess their operating strategy.

Negating the Impact of Leverage on Net Income

Many companies use debt to reduce tax expenses. Debt reduces pre-tax net income. However, their low net income may not be due to poor performance, but due to high-interest expenses. Therefore, comparing the net income of companies with different financing structures does not give a real picture of their performance. NOPAT is a more accurate indicator of the operational efficiency of leveraged companies.

Analyzing NOPAT

NOPAT is a useful metric to better understand the operating efficiency of a company. It helps analysts to understand how profitable a company’s core operations are without the impact of capital structure. As with many financial metrics, comparison is most useful to peers and over a period of time. Standalone figures provide only a snapshot and are in some way meaningless without a benchmark. This benchmark can be the company’s historical year’s NOPAT or a comparable company’s operating in a similar industry.