The concept of a company’s normalized earning power is central to reaching a proper valuation of a company’s worth. While normalized earning power cannot be determined with absolute precision, it is critical that efforts be made to estimate its level.
The idea of normalized earning power derives from the fact that almost all companies have some cyclicality to their businesses; their operating results tend to bounce around from year to year, even though the long-term trend might be up. When valuing a company, it is important to pick a level of earnings that the company can realistically sustain over time. Choosing an earnings level created during a particularly robust (or poor) operating period for the company will give a distorted picture of the level of sustainable earnings for the company during more normal times.
The foregoing issue is highlighted when the price-to-earnings ratio (“p/e ratio”) is used, among other valuation tools, to assess the attractiveness of a potential investment. The p/e ratio is simply the current market price of a stock divided by its actual (or estimated) earnings per share over a certain period.
The proper way to use the p/e ratio as a valuation tool is to adjust the “e” part of the equation to normalized earnings rather than reported earnings according to generally accepted accounting principles. Normalized earnings are reported earnings that are adjusted for the impact of events properly considered transitory or non-recurring in nature. Long-term investors should focus on normalized earnings rather than accept earnings that companies report on their face without any such adjustments. Failure to focus on normalized earnings could distort the “e” part of the p/e ratio, leading to misleading conclusions about whether a stock is undervalued.
Knowing how to make these adjustments requires a good understanding of the company’s business and the industry in which it operates. Most of our clients do not have the time or interest to do this. Here at PDV, we undertake this work as part of our research efforts in discovering undervalued securities for our clients.