Answer 2

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Normalizing Earnings

If you plan to base your future operating income on current operating income, it stands to reason that you want to remove any items that are transitional (one time charges or income) or cancel out over time (exchange rate or pension fund gains or losses). It is a tougher call as to whether you should smooth out operating income by using the average income over time. For some firms, such as commodity companies, it clearly makes sense given the ups and downs in commodity prices over time. For other firms, especially those that are facing long term structural or operating problems, you should not replace current depressed earnings with an average earnings over time. Instead, you should recognize that the earnings improvement, if it occurs, will happen gradually over time and reflect that in your valuation by a gradual improvement in operating margins.



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