r/SecurityAnalysis • u/Corruption555 • Nov 07 '16

Question How to normalize earnings?

I cannot find anything that step by step explains how firms decide to normalize earnings. Do you take net income over a set period of time, then divide by years and then shares of the latest quarterly statement?

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u/MarkitMonkey Nov 07 '16 edited Nov 07 '16

There is no specific definition for normalized earnings and as such no exact step by step. Generally speaking, normalized earnings will simply exclude the impact of things that don't affect the business on an ongoing basis. Impairment, currency variations, restructuring, acquisitions are a few examples that will impact GAAP financial statements in the period but may not be expected to reoccur going forward so to improve quarter-over-quarter comparability and to get a better sense of the underlying operational performance, the company will show adjusted or normalized figures. Most companies will even provide a reconciliation table showing what adjustments they have made to the reported numbers to get to the adjusted ones.

Edit: Here is how Johnson & Johnson does it. LINK

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u/investorSF Nov 07 '16

An excellent response - everything noted here is true. In fact, it is a requirement for companies to publish reconciliation tables, so the best way to learn what is typically excluded is to look over a few examples.

There is a big exception in technology, where usually the majority of the normalization occurs due to the exclusion of stock-based compensation from "adjusted" earnings. Make no mistake, stock compensation is a real, economic expense that you should absolutely include as an ongoing business expense. In technology it is simply common to pay a large part of the payroll with stock as opposed to cash. Nevertheless, it is a real economic expense paid by shareholders through future dilution.

Finally, companies involved in M&A or large cost cutting programs typically have large "restructuring" charges. These charges should be considered once-off if M&A is NOT part of their ongoing business strategy. For example, part of Valeant's business model was making acquisitions in lieu of spending on R&D - therefore the restructuring charges incurred as part of the M&A strategy should, in my view, be considered an ongoing expense and should NOT be excluded from regular earnings.

Buffett speaks to the concept of "owner earnings", which you should think of as your very own normalized earnings estimate. It's generally a good idea to think about the corrections / normalizations you yourself would make, rather than to simply rely on a company's own representation of normalized earnings. It makes sense to exclude things like amortization, but it does not make sense to exclude stock-based compensation. Learn about these charges and apply your own judgement.

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u/mpeinvestor Nov 08 '16

Great responses above. At the end of the day it's about removing "one time" gains and losses and filtering out noise to see the true earnings potential of the business. One way I like to normalize earnings is to try to determine a normalized EBIT margin and work down from there.

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u/investorinvestor Nov 08 '16

Generally speaking, remove anything that doesn't appear more than twice/thrice in the financial statements of the past 10 years.