Economic Income
Economic income is typically determined as cash flow during the period plus the change in the present value of expected future cash flows, typically represented by the change in the market value of the business’s net assets. Under this definition, income includes both realized (cash flow) and unrealized (holding gain or loss) components. This concept of income is similar to how we measure the return on a security or a portfolio of securities that is, return includes both dividends and capital appreciation. Economic income measures change in shareholder value. As such, economic income is useful when the objective of analysis is determining the exact return to the shareholder for the period. In a sense, economic income is the bottom-line indicator of company performance measuring the financial effects of all events for the period in a comprehensive manner. However, because of its comprehensive nature, economic income includes both recurring and nonrecurring components and is therefore less useful forforecasting future earnings potential.
Economic income is typically determined as cash flow during the period plus the change in the present value of expected future cash flows, typically represented by the change in the market value of the business’s net assets. Under this definition, income includes both realized (cash flow) and unrealized (holding gain or loss) components. This concept of income is similar to how we measure the return on a security or a portfolio of securities that is, return includes both dividends and capital appreciation. Economic income measures change in shareholder value. As such, economic income is useful when the objective of analysis is determining the exact return to the shareholder for the period. In a sense, economic income is the bottom-line indicator of company performance measuring the financial effects of all events for the period in a comprehensive manner. However, because of its comprehensive nature, economic income includes both recurring and nonrecurring components and is therefore less useful forforecasting future earnings potential.
Permanent Income
Permanent income (also called sustainable income or recurring income) is the stable average income that a business is expected to earn over its life, given the current state of its business conditions. Permanent income reflects a long-term focus. Because of this, permanent income is conceptually similar to sustainable earning power, which is an important concept for both equity valuation and credit analysis. Benjamin Graham, the mentor of investing guru Warren Buffett and the father of fundamental analysis, maintained that the single most important indicator of a company’s value is its sustainable earning power. Unlike economic income, which measures change in company value, permanent income is directly proportional to company value. In particular, for a going concern, company value can be expressed by dividing permanent income by the cost of capital. Because of this relation, determining a company’s permanent income is a major quest for many analysts. However, although permanent income has a long-term connotation, it can change whenever the long-term earnings prospects of a company are altered.
Operating Income
An alternative concept is that of operating income, which refers to income that arises from a company’s operating activities. Finance textbooks often refer to this income measure as net operating profit after tax (NOPAT). The key feature of operating income is that it excludes all expenses (or income) that arises from the business’s financing activities (i.e., the treasury function), such interest expense and investment income, which collectively are called nonoperating income. Operating income is an important concept in valuation its importance arises from the goal of corporate finance to separate the operating activities of the business from the financing (or treasury) activities. Conceptually, operating income is a distinctly different concept to that of permanent income; operating income may include certain nonrecurring components such as restructuring charges, while recurring components such as interest expense are excluded from operating income.
Permanent income (also called sustainable income or recurring income) is the stable average income that a business is expected to earn over its life, given the current state of its business conditions. Permanent income reflects a long-term focus. Because of this, permanent income is conceptually similar to sustainable earning power, which is an important concept for both equity valuation and credit analysis. Benjamin Graham, the mentor of investing guru Warren Buffett and the father of fundamental analysis, maintained that the single most important indicator of a company’s value is its sustainable earning power. Unlike economic income, which measures change in company value, permanent income is directly proportional to company value. In particular, for a going concern, company value can be expressed by dividing permanent income by the cost of capital. Because of this relation, determining a company’s permanent income is a major quest for many analysts. However, although permanent income has a long-term connotation, it can change whenever the long-term earnings prospects of a company are altered.
Operating Income
An alternative concept is that of operating income, which refers to income that arises from a company’s operating activities. Finance textbooks often refer to this income measure as net operating profit after tax (NOPAT). The key feature of operating income is that it excludes all expenses (or income) that arises from the business’s financing activities (i.e., the treasury function), such interest expense and investment income, which collectively are called nonoperating income. Operating income is an important concept in valuation its importance arises from the goal of corporate finance to separate the operating activities of the business from the financing (or treasury) activities. Conceptually, operating income is a distinctly different concept to that of permanent income; operating income may include certain nonrecurring components such as restructuring charges, while recurring components such as interest expense are excluded from operating income.
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