Earnings are the profits that a company reports to its shareholders. Investors use earnings to judge a company's performance -- its gains and falls in earnings usually affect the stock price. By normalizing earnings, analysts average a company's earnings over a period of time to get a more accurate account of its financial productivity. This is useful for companies that have seasonal sales periods or to factor economic cycles into a company's long-term earnings outlook. The price-earnings ratio is a tool investors use to evaluate a stock's price by comparing it to the company's earnings. Using the normalized P/E ratio, investors get a long-term value of a stock by filtering out short-term changes to earning by using the company's normalized earnings.
The price-earnings ratio is a tool that helps investors judge the true value of a stock's price. Generally, the ratio is calculated by dividing the company's "trailing" earnings-per-share, which covers the past 12 months of operations, into the stock's current price. The price-earnings ratio tells investors how much they're paying for $1 of earnings, with a lower number implying more value. The price-earnings ratio can help investors compare stocks of different prices. For example, a company whose stock price is $20 and earnings-per-share is $5 has a P/E ratio of 4, which is more valuable than a $40 stock for a company that also posts $5 earnings, giving it a P/E ratio of 8.
There are several business or economic cycles that can affect a company's regular earnings and give a misleading report on the company's performance. For examples, many retailers are dependent upon sales in the holiday season, which can inflate earnings around these periods and give an inaccurate view of the company's health. Long-term economic cycles like a recession or other one-time events, such as a natural disaster, can also affect a company's earnings and warrant use of normalized earnings. Normalizing earnings will also help investors account for changes in the company's operations, such as selling major assets or financial restructuring.
Using the P/E Ratio
The price-earnings ratio is often used by investors to compare the value of one company's stock against another's, or to compare a company's stock value against the trend in its industry sector. P/E ratios can vary between industry, company size and, in the case of businesses with cyclical operations, the time of year or the economic climate. Depending upon when a company reports earnings, a low P/E ratio means that a company's earnings may be at its peak while a high P/E ratio could mean the business is in its slow season. According to Morningstar, normalized earnings provide a smoother overview of the company's performance and avoid over-reliance on a single year of a stock's reported earning.
Using Normalized Earnings
Companies and financial information firms will often provide normalized earnings over five-, 10- or 15-year periods. Normalized earnings are sometimes reported on quarterly or yearly earnings reports. Online brokers and investment services usually have available a range of normalized-earnings data on publicly traded companies. There are several ways that normalized earnings can be calculated, some of which take into account issues like inflation or company growth that can skew short-term earnings reports. For example, by adjusting a company's yearly earnings by its return on equity, investors can evaluate the year-to-year earnings of a company that is growing.
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