Normalized EPS

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Last Updated:February 2, 2024

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What is Normalized EPS?

Normalized EPS adjusts earnings for one-time or non-recurring items, providing a clearer picture of a company's core profitability by excluding irregularities.

The main goal of Normalized EPS is to convey a better earnings number that reflects the actual profitability of the business.

We use the income statements from the previous year to calculate normalized earnings per share. When a company has high normalized earnings per share, it clearly shows high earnings, thus, high profitability.

This can indicate the company's financial strength and profitability regardless of the economy's condition.

These adjustments are mainly used when the company is being set up for sale. As a result, a one-time expense that is not part of the company's normal business operations affects its EPS and value.

Also, investors prefer to check the company's average earnings over a specific period. This pushes the company's management that wants to prepare a normalized earnings report or add it to its income statement, reflecting the company's financial performance over time.

Doing this every single year will be problematic for investors. This might give the idea that the company is inflating its numbers yearly to give the illusion that it is in good financial health.

Key Takeaways

Normalized EPS, or Earnings Per Share, adjusts a company's earnings by excluding one-time or non-recurring items, providing a clearer view of the company's core profitability.
High normalized EPS suggests strong earnings and profitability, indicating the company's financial strength irrespective of economic conditions.
Normalized EPS differs by excluding one-time expenses, providing a stable and accurate picture of a company's financial health over time.
Normalization occurs through addressing cyclicality, adjusting for private companies, and using non-GAAP measures to focus on essential business operations.

Understanding Normalized EPS

Earnings per share is an investing metric that measures profitability per share. It allows an investor to easily understand a company's profitability while accounting for its outstanding shares.

EPS is an important metric for investors, as it can provide insight into a company's profitability and value. Generally, companies with a high EPS are more profitable than companies with lower earnings per share.

Keep in mind that this is not a measure of absolute profitability. Instead, it is profitability measured on a per-share basis.

This metric is calculated by dividing a company's net income by the number of outstanding shares. Some companies refer to net income as profit/earnings. These terms are equivalent, and we aim to see how much money the company earned after expenses.

The normalized earnings per share and EPS are similar as they portray a company's profitability. However, the difference between both metrics is that the normalized EPS considers the unusual one-time expenses that are not in the company's normal business operations.

By ignoring the one-time expenses, the company can show its true financial position/health by portraying a clear image of its financial position regardless of the one-time expenses the business may have endured.

Example of Normalized Earnings

An example of how a company's EPS is affected

A recent example of normalized earnings is XYZ's Q2 2020 earnings. During the quarter, the company paid a large one-time amount to settle a case: the settlement ($25.4 million) or 2% of revenue.

The company's earnings report included an adjusted earnings number that accounted for this expense and other acquisition-related costs as one-time costs. Therefore, the company's GAAP computations were less accurate than its non-GAAP figures.

It's similar to taking out a one-time emergency expense from your last month's spending totals to understand better how closely you adhered to your monthly budget.

It is important to understand why these changes are occurring within the company because the same expenses removed might be added back to the income statement.

Types of Normalized EPS

Usually, normalization occurs in three main different ways. Whether it's to smooth sales cycles, remove one-time expenses, or even normalize remarkably high one-off costs or earnings.

1. Cyclicality of Seasonality

Financial analysts use the term cyclicality. Therefore, companies whose revenues are heavily impacted by market cycles are called cyclical businesses. The companies that fall into this category are global hotels & resorts, where revenues fluctuate positively in periods of high economic growth and negatively in periods of slow economic growth.

Balancing out the earnings of a cyclical income requires the company to take its net income average over the last five years.

Remember

This works for mature companies but is useless for small companies that are still growing. It's illogical to assume a market cycle will cause a company's revenue to increase from $8 million to $30 million in 4 years.

2. Adjustments for private companies

This is applied to a private company's earnings to reflect what the company would earn if it were public. Business valuators implement these practices to gain a better insight into the value of the private business going on sale more accurately.

Adjustments for normalization are applied to the amounts shown on financial statements like the income statement and balance sheet. Two main categories of financial statement changes can be distinguished:

Normalization modifications
Control Adjustments

To convert a private firm's earnings to a "fairly well run, public company equivalent basis," normalization modifications are performed.

In other words, these adjustments represent how a private company's earnings would appear to a knowledgeable outside investor who used data from public firms as a benchmark to determine the subject company's fair market worth.

Control changes are done "for the economies and efficiency of the typical financial buyer and the synergies or strategies of individual purchasers," according to the control adjustments manual. The second category of control modifications is more relevant to investment value (i.e., value to a specific buyer).

Although both types of adjustments ultimately will affect value, this distinction provides a framework to consider why a particular adjustment should be made.

3. Non-GAAP Adjustments

Companies use non-GAAP measures to convey a company's financial position.

Management of the company uses these measures to focus on the business's core operations disregarding the one-time charges and other expenses that they believe are not essential to value the company. Such as paying a one-time legal settlement fee.

Note

In the United States, a non-GAAP measure is subject to the Securities Exchange Commission's non-GAAP rules.

One of the most important parts of the financial reporting process is the non-GAAP measures. Therefore, the management needs to evaluate which non-GAAP measures it chooses to portray to investors by using the common guidelines applied in the industry.

Finally, having a clear and trustworthy disclosure of non-GAAP measures is key. Investors losing trust in the management's financial reports can be catastrophic to the overall business value and reputation.

That's why management always reviews its measures with its audit committee, its board of directors, and sometimes an independent board that enhances the overall quality of the reporting.

This ensures that these adjustments are trustworthy and based on sound business/financial decisions that will maximize the overall business value in the long run.