What Are Normalized Earnings?

Normalized Earnings Explained in Less Than 5 Minutes

Definition
“Normalized earnings” is an all-encompassing term for net income that has been adjusted for seasonality, cyclicality, one-time expenses, and other items such as related-party transactions. The metric is meant to produce an earnings number that better reflects the actual operations of the business.
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“Normalized earnings” is an all-encompassing term for net income that has been adjusted for seasonality, cyclicality, one-time expenses, and other items such as related-party transactions. The metric is meant to produce an earnings number that better reflects the actual operations of the business.

Definition and Examples of Normalized Earnings

Normalized earnings are earnings that have been adjusted to better reflect the core operations of a business. Normalized earnings can be earnings adjusted for one-time or otherwise extraordinary items, or earnings adjusted for seasonality or cyclicality. In both instances, earnings are adjusted to give a more normal picture. Normalizing earnings is a common practice among business valuation practitioners, but may be problematic for stocks that do it every year.

A recent example of normalized earnings is Lululemon’s Q3 2021 earnings. During the quarter, the company made an acquisition that included one-time compensation costs to move the acquired company’s CEO into an advisory role. The compensation ($23.8 million) was 1.6% of revenue.

Because this expense is considered one-time, the company included an adjusted earnings number in its earnings report that included it and some other acquisition-related expenses. Consequently, the company’s GAAP calculations were lower than its non-GAAP calculations. It’s like how you might eliminate a one-time emergency expense from your spending totals last month so you can get a more accurate picture of how closely you followed your monthly budget.

Note

Normalized earnings is not always this easy to understand. Some companies will add-back the same one-time charges every year. It’s important to understand why a company is normalizing earnings to decide whether the new number is accurate.

How Do Normalized Earnings Work?

Normalized earnings as a term is most commonly used in the business valuation industry. Business valuation firms often need to value private businesses that have unreliable net income numbers because of related party transactions and potentially higher-than-market compensation.

Businesses are valued based on a multiple of earnings or on a discounted sum of future earnings. If cyclicality or one-time items make the reported net income inaccurate, the whole valuation will be off.

Note

Presentation of normalized earnings is common among public companies that want to show better earnings numbers. In this context, the company usually calls the normalized number “adjusted net income” or “adjusted earnings per share (EPS).”

Types of Normalized Earnings

Here are a few of the common adjustments made to normalize earnings.

Cyclicality or Seasonality

Cyclical businesses are businesses that are heavily impacted by market cycles, such as new car manufacturers or big-screen TV manufacturers. This is the most common use of the term by public stock market analysts. It is to smooth out the earnings number. The easiest way to do this is to take the average net income of the last five years. If the current net income is at a cyclical high, or low, it should be balanced out by the five years of numbers.

Earnings smoothing like this doesn’t work for small companies that are still in a hyper-growth phase. If a business had $10 million in revenue three years ago and $100 million this year, it’s unlikely that the jump is due to a market cycle.

Note

An example of normalized earnings is the cyclically adjusted price/ earnings ratio (CAPE), which is a common valuation measure for the stock market as a whole.

Non-GAAP Adjustments

Non-GAAP adjustments are adjustments made to Generally Accepted Accounting Principles (GAAP) net income by public companies.

Companies that have one-time expenses, like Lulelemon, are making non-GAAP adjustments. Restructuring, gains/losses on the sale of assets, litigation settlements, and tax-related expenses are also common non-GAAP adjustments.

Public Equivalent Adjustments

These are adjustments made to the earnings of a private company to reflect what the company would earn if it were a public company. These adjustments are made to better value a private business that is for sale.

Common examples of public equivalent adjustments are:

  • Compensation add-backs for relatives who are on the payroll but aren’t necessary
  • Rent paid to a related party that is above or below market
  • Additional compensation for owners who acted as managers but were not paid salaries

What It Means for Individual Investors

Individual investors doing valuation analysis should consider doing some earnings normalization for stalwart businesses that have recently experienced a big jump in earnings that could be cyclical. If you’re analyzing a natural gas company, for example, and natural gas prices are at all-time highs, you may want to adjust downward your assessment of the company’s earnings over the past few years to be conservative in your analysis.

Remember, though, that non-GAAP adjustments are risky. The Securities and Exchange Commission (SEC) and Financials Accounting Standards Board (FASB) have taken notice of how many companies use non-GAAP measures to mislead investors. When you’re reviewing a company’s financial documents, it’s important to understand why the company is making non-GAAP adjustments. If you don’t understand or don’t agree, stick to the GAAP numbers.

Key Takeaways

  • Normalized earnings are adjusted to present a normal picture of a business.
  • Earnings can be normalized for a number of reasons, including one-times items, smoothing out cyclicality, and for private business net income.
  • Be wary of stocks that report normalized earnings every year.
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Sources
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  1. lululemon athletica. "lululemon athletica inc. Announces Third Quarter Fiscal 2021 Results."

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