More on normalizing earnings

For cyclical firms, the easiest solution
to the problem of volatile earnings over time and negative earnings in the base
period is to normalize earnings. When normalizing earnings for a firm with
negative earnings, we are simply trying to answer the question: ÒWhat would
this firm earn in a normal year?Ó Implicit in this statement is the assumption
that the current year is not a normal year and that earnings will recover
quickly to normal levels. This approach, therefore, is most appropriate for
cyclical firms in mature businesses. There are a number of ways in which earnings
can be normalized.

*Average the firmÕs dollar earnings over prior periods*: The simplest way to normalize earnings is to use the average earnings over prior periods. How many periods should you go back in time? For cyclical firms, you should go back long enough to cover an entire economic cycle Ð between 5 and 10 years. While this approach is simple, it is best suited for firms that have not changed in scale (or size) over the period. If it is applied to a firm that has become larger or smaller (in terms of the number of units it sells or total revenues) over time, it will result in a normalized estimate that is incorrect.- Average
the firmÕs return on investment or profit margins over prior periods: This
approach is similar to the first one, but the averaging is done on scaled
earnings instead of dollar earnings. The advantage of the approach is that
it allows the normalized earnings estimate to reflect the current size of
the firm. Thus, a firm with an average return on capital of 12% over prior
periods and a current capital invested of $1,000 million would have
normalized operating income of $120 million. Using average return on
equity and book value of equity yields normalized net income. A close
variant of this approach is to estimate the average operating or net
margin in prior periods and apply this margin to current revenues to
arrive at normalized operating or net income. The advantage of working
with revenues is that they are less susceptible to manipulation by
accountants.

There
is one final question that we have to deal with when normalizing earnings and
it relates to __when earnings will be normalized__. Replacing current
earnings with normalized earnings essentially is equivalent to assuming that
normalization will occur instantaneously (i.e., in the very first time period
of the valuation). If earnings will be normalized over several periods, the
value obtained by normalizing current earnings will be too high. A simple
correction that can be applied is to discount the value back by the number of
periods it will take to normalize earnings.