While evaluating a company using a multiple such as P/E ratio, an important question is what earnings one should use. There is too much clutter and differences in how companies report their earnings and if the security analyst is not careful, it’s very easy to get swayed by the hidden charges. Here are a few lessons that you should keep in mind while calculating the Earnings per Share that you can use confidently in your relative valuation.
- Use average earnings. Do not depend on a single year’s earnings. Instead of using just the current year’s earnings, you can get a better estimate of the company’s value by taking the average of the past three years. By taking the average, you will smooth out any special charges that the company may have put in a particular year. For example, a company may report its primary earnings as $5 per share. Then they may have another value Net Income After Special Charges as $4. In such a case which figure should you use for earnings? $5 or $4? You may investigate what these special charges are and decide what to do with them. However, instead of taking just one year’s earnings, if you average out 3+ years of earnings, the problem of special charges will be ironed out.
- Calculate past growth rate using average earnings. Again instead of calculating growth rate based on just the latest figures for single years, it is suggested that you compare the 3-year average earnings 10 years back with the 3-year average earnings for the past 3 years.
- Beware of pro forma earnings. Companies release pro forma earnings press releases to show what they would have earned if certain event had not happened. For example, if they had not paid that preferred stock dividend, or if they had not acquired that company. The best thing to do with these pro forma earnings is to completely ignore them.
- Pay attention to Revenue Recognition. You need to carefully recognize how the company recognizes revenues, and if it is recognizing any revenues too early. Any aggressive revenue recognition is a sign of danger.
- Look for capital offences. Any capital expenditure should not be expensed and any revenue expenditure should not be capitalized. Simple. Companies however keep breaking this law. By using corrupt accounting practices, companies can easily convert regular operating expenditure into capitalized assets and boost their profits.
- Check for inventory levels. This is the most commonly manipulated figure. A company losing sales may end up with so much inventory that it may eventually have to write down the inventory. This would be a nonrecurring event. However, what would you make out if the company is writing down inventory every year?
