Earnings Measures

Understanding Sustainable Earnings

Sustainable earnings are also called permanent earnings and non-sustainable earnings are called transitory earnings.

Market Capitalization

• Company’s fair market value • Market price per share × Number of shares

outstanding (for public companies)• Reflects the capital market’s outlook regarding the

company’s future performance• And, hopefully, reflects the true intrinsic value of a

company– As a going concern – The value the company can be sold for in an efficient

market 3

Earnings

• Sustainable (permanent) earnings– The level of earnings expected to persist.

• Transitory earnings– Earnings that are non-sustainable– Include single-period, non-recurring amounts

• Extraordinary gains/losses• Restructuring charges• Changes in accounting principle• Discontinued operations

4

Persistence on the Income Statement

5

Greater Persistence

LessPersistence

Amounts more central to a

company’s core operations are reported first.

Revenues $424,000 Cost of goods sold 238,000 Gross profit 186,000 Operating expenses 95,000 Operating income 91,000 Interest income 1,500 Interest expense -3,400 Income before income taxes 89,100 Income taxes expense 28,500 Income from continuing operations 60,600Discontinued Operations: Operating loss from discontinued operations, net of taxes of $310 -920 Gain on discontinued operations, net of taxes of $1,650 5,220Income before extraordinary loss and cumulative effect of a change in accounting prin. 64,900 Extraordinary gain(loss) from hurricane, net of tax -1,100 Income before cumulative effect of accounting principle change, net of tax 63,800 Cumulative effect of a change in accounting principle, net of tax 3,200 Net income $67,000

Special Income Statement Items

• Typically include– Gains and losses from the sale of long-lived assets– Litigation settlements– Impairment charges for long-lived assets– Restructuring charges – Change in accounting principle– Extraordinary gains and losses– Discontinued operations

6

Extraordinary Gains and Losses

• Gains and losses that are both– Unusual, and– Infrequent

• Reported as a one-time effect, net of taxes• Examples– Natural disasters in areas where the cause is not

usual and infrequent– Asset appropriations by foreign governments

7

Earnings Per Share (EPS)• Represents the profit earned by a company per share

of common stock held by shareholders• Public companies must report– Basic EPS =

Net income ÷ Number of common shares outstanding

– Diluted EPS =

8

Net income ÷Number of common shares

outstanding adjusted for diluted claims

Investigate

• Pick a public company• Find their most recent annual report• Answer these questions– What were their net income, basic EPS, and diluted EPS?– Did they have any special items? What were they?

• Look up their current stock price and number of shares outstanding.– Compute their market capitalization– Compare stock price to earnings per share? What does

that tell you?