Wall Street focuses a large amount of its time on earnings; analysts spend most of their time forecasting earnings projections; every company has an earnings call every quarter, and for Wall Street, earnings are a big deal. But what does one do when earnings are experiencing large fluctuations because of one-off transactions? How do we determine the true picture of a company’s financial health?
The answer is normalized earnings.
When a company has lumpy earnings or a situation that either decreases or increases the earnings by a large amount, it can make analyzing the company tricky.
By discovering the trick to normalizing a company’s earnings, we can help smooth out the results and make analyzing the company easier and more consistent.
In today’s post, we will cover the following:
- What are Normalized Earnings?
- Understanding Normalized Earnings
- How to Normalize Earnings Using Average Return on Equity
- How to Normalize Earnings Using Average Net Margin
Ok, let’s dive in and learn more about normalized earnings.
What Are Normalized Earnings?
According to Investopedia:
“Normalized earnings are adjusted to remove the effects of seasonality, revenue and expenses that are unusual or one-time influences. Normalized earnings help business owners, financial analysts, and other stakeholders understand a company’s true earnings from its normal operations.”
Macy’s offers a great example by removing a land sale from its financial statements in which it realized a large capital gain from the sale. The removal would be because Macy’s sells products, not land, which is Macy’s real business.
Earnings tend to have a bad rap in the value investing community, and with good reason. The extreme focus by Wall Street leads to all sorts of bias from not only the analysts, but the advisors buying or selling the companies.
I prefer using free cash flow or owners’ earnings, but those methods also have their issues. Sometimes it’s easier to throw out companies with negative or erratic cash flows.
The other option is to look up analyst earnings estimates on your favorite financial website, such as Yahoo, which is incredibly easy.
But as Professor Damodaran says in his finance classes:
“They must know something you don’t.”
But using analysts’ earnings can remain fraught with a bias that can lead to “irrational exuberance.” It is a known fact that analysts are often wrong; if you don’t believe me, do a simple Google search for how often equity analysts get it right.
Let’s look at normalized earnings better, and then we can dive into how to normalize our earnings.
Understanding Normalized Earnings
Normalized earnings represent a company minus one-off charges by omitting these non-recurring charges or gains. Normalizing the earnings helps better represent the core business of the company. We remove those one-off effects as the effects on profits and losses as they can muddy our results.
Cyclical or seasonal companies are great examples of businesses that benefit from normalizing their earnings.
In short, normalized earnings best represent the most accurate assessment of a company’s financial health and performance. All companies, at some point, experience one-off transactions that can affect a company’s financial results. For example, lawyer fees in the case of Wells Fargo as they defend themselves due to their fake account scandal that has rocked the bank. Another example would be selling old equipment or maybe one-off gains from selling a business.
In all of the above cases, the company records expenses and revenues on the company’s financial statements and realizes the effects on free cash flow. They are not indications of Wells Fargo’s long-term performance and must be adjusted.
To recap, normalized earnings remove one-off expenses or revenues and allow the smoothing of earnings of the company. Normalized earnings better represent the true financial performance of the company. Normalized earnings per share can be used as a tool to compare two companies, especially when one of the companies has experienced an event benefiting or causing the suffering of the business.
How to normalize earnings
Now that we understand what normalized earnings are, the benefits of normalizing earnings, and how they can help us better analyze a business, let’s look quickly at how we would normalize the earnings.
From Professor Damodaran‘s class on valuation:
“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.”
The last line cuts to the heart of removing biases and any manipulations that can occur in earnings. Not that these situations remain common, but removing any opportunity for fraud offers one less worry.
Ok, now that we understand all the background on normalized earnings, let’s start to put these ideas into practice.
How to Normalize Earnings with Average Return on Equity
The first method we will dive into uses the return on equity ratio.
Return on Equity
The reason we are using a return on equity, again, comes from Professor Damodaran:
“Using average return on equity and book value of equity yields normalized net income.”
We will use Verizon (VZ) as our first guinea pig. The telecommunications giant has a market cap of $227.5 billion and a current market price of $54.87.
The first thing to do is lay out the steps we need to follow to find the normalized earnings in relation to return on equity.
Steps:
- Get the last four years and TTM Return on Equity
- Find the average of the return on equities
- Multiply the average return on equity from above by the latest shareholder’s equity number from the balance sheet, which normalizes the net income.
- Divide the above number by the shares outstanding to get our normalized earnings.
Not too bad, huh?
Let’s gather our numbers from our calculations, balance sheet, and income statement. At this stage, I will not bore you with calculating the return on equity for five years of financials. I will do this on a separate spreadsheet, but you can easily do this yourself if you follow the above link to do calculations yourself. Or, you can use the data from your favorite financial website to make it even simpler.
I am a nerd, and I like to calculate ratios because it ensures I understand where the numbers come from and how everything interconnects. Plus, any time I am forced to spend time with the financials is more time that I am familiarizing myself with the company.
Ok, let’s gather our numbers for Verizon and normalize our earnings.
Return on Equity:
- 2018 – 32.3%
- 2019 – 33.7%
- 2020 – 27.8%
- 2021 – 29.5%
- TTM – 26.2%
Average ROE for the period – 29.9%
Shareholder’s Equity for Verizon for TTM – $87, 357 million
Shares Outstanding from the Income Statement TTM – 4,178
Let’s find our normalized earnings.
Normalized earnings = ($87,357 x 29.9% )/ 4,178
Normalized earnings = $6.25 per share
The process remains simple if we compare that to what Yahoo finance predicts for the current year for Verizon. Analysts predict earnings per share of $4.81 for 2022 and $5.18 for 2023.
Now our number looks quite a bit higher than what the analysts predict. We can think about this in multiple ways; first, we did our calculations wrong, which is entirely possible. We could use too long of a period for Verizon, with the company still growing and the company’s ROEs continuing to remain high. Another option is instead of using the average, which included a few quite high numbers, maybe we use the mean of the ROE to give us a more conservative number.
Let’s take a look at both examples to see the results. Remember, it is not enough to plug in numbers; we must also think about our results and ask if we think this is likely.
If we use a shorter time, such as three years, and average the last three years, we get an average ROE of 27.63, and if we find the mean of the above ROE, we get a number of 27.5.
Now, plug our new ROE into the formula and see our results.
- Normalized earnings = ( $87,357 x 27.63% ) / 4,178
- Normalized earnings = $5.77 earnings per share for our three-year average ROE
- Normalized earnings = ( $87,357 x 27.5% ) / 4178
- Normalized earnings = $5.75 earnings per share for our mean ROE
I don’t know about you, but I feel that the above numbers with either the short time horizon for averages or the mean are better than the first calculations.
Let’s try this on another company, say Johnson and Johnson (JNJ).
I will find the mean of the return on equities for Johnson and Johnson and use that number instead of the average.
Return on Equity:
- 2018 – 25.5%
- 2019 – 25.4%
- 2020 – 24.0%
- 2021 – 30.4%
- TTM – 25.2%
This means that the above five years of return on equity equals 26.1%
Total shareholders’ equity for Johnson and Johnson from the latest balance sheet equals $76,357 million.
And the total share outstanding from the TTM income statement equals 2,672.
Now, plug our numbers into the calculations to find the normalized earnings.
Normalized earnings = ( $75,357 x 26.1% ) / 2672
Normalized earnings = $7.36 earnings per share.
Compare this to the current analyst’s earnings predictions for 2022 of $8.17 and 2023 of $9.01.
Let’s try one more, Wells Fargo (WFC).
The mean return on equity is 9.24%, the total shareholders’ equity from the latest balance sheet is $179,793 million, and the shares outstanding from the TTM are 3,936.
We are plugging the above numbers into our formula.
Normalized earnings = ( $179,873 x 9.24% ) / 3936
Normalized earnings = $4.22 earnings per share
Yahoo finance predicts 2022 earnings per share of $3.96 and earnings per share for 2023 of $5.08.
The above numbers make sense because the market continues punishing Wells Fargo for the potential losses predicted from the pandemic and the fallout from the fake account scandal. Looking at Wells Fargo’s earnings before this TTM, you can see them in line with our calculations.
Okay, now that we have a good handle of normalizing earnings using the return on equity, let’s explore the other option available.
How to Normalize Earnings with Average Net Margin
Let’s look at how we can use revenues to normalize earnings for our company.
According to Professor Damodaran, we can “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.”
To find the net margin, we take our earnings from the line item of the income statement and divide that number by the revenue number from the income statement. The calculation gives you the net margin of earnings in relation to the total revenue of any business.
For example, if we look at Wells Fargo, their total revenue for 2021 was $82,948 million, and the net earnings were $23,238 million. Dividing the earnings by revenue gives us a net margin percentage of 24.4%.
The steps we need to follow to normalize earnings are as follows:
- Calculate the net earnings for the last three years and the TTM.
- Take the average of our net earnings.
- Multiply the average of our net earnings by the company’s total revenue.
- Divide the results of the multiplication by the outstanding shares.
Okay, let’s look at this process using Wells Fargo since we already normalized its earnings using the return on equity process.
Net margin:
- 2018 – 24.4%
- 2019 – 21.5%
- 2020 – 3.0%
- 2021 – 24.4%
- TTM – 21.5
- Average = 18.96%
Total revenue for Wells Fargo from the TTM is $82,948 million, and the shares outstanding from the income statement is 3,936.
Now that we have all our numbers, let’s plug in everything.
Normalized earnings = ( $82,948 x 18.96% ) / 3,936
Normalized earnings = $4.00 earnings per share
Ok, pretty easy; let’s look at another one.
The next company I would like to examine is AT&T (T), the telecommunications giant.
AT&T’s average net margin for the past five years equals 7.6%.
Total revenues for AT&T from the TTM is $156,602, and the total shares outstanding from the latest income statement is 7,250.
Now, let’s plug in our numbers to find the normalized earnings for AT&T.
Normalized earnings = ( $156,602 x 7.6% ) / 7250
Normalized earnings = $1.64 earnings per share
If we compare our calculations for the normalized earnings for AT&T to the numbers from Yahoo, we get analysts’ earnings of $2.32 for 2022 and $2.36 for 2023.
Ok, that will wrap up our discussion of normalizing earnings using the net margin method.
On one other note, when calculating these earnings, we can always use five years for our averages. Try not to remain conservative for conservative’s sake; a growth company using a longer period might level out the growth periods.
Final Thoughts
Normalizing earnings doesn’t present challenging math, and the methods we explored above won’t tax you as far as the math is concerned. As with all calculations, we need to understand the inputs to interpret the results.
As with any formula or calculation, plugging in numbers, taking the result, and running with it is not in your best interest. Use the normalized earnings to give you a better context about insights with the company over a longer horizon than just today or the next quarter.
Wells Fargo focuses a lot of energy on what’s coming next and reacting positively or negatively to whatever news is presented to the market, regardless of the context. Normalizing the earnings of any business helps counteract any of the reactions and can help you analyze any company you investigate.
And with that, we will wrap up our discussion for today. As always, thank you for taking the time to read this post, and I hope you find something of value on your investing journey.
If I can be of any further assistance, please don’t hesitate to reach out.
Until next time.
Take care and be safe out there,
Dave
