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: “What would this firm earn in a normal year?” 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.

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.