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.

• Average the firm’s 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 – 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 firm’s 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.