Adjusting current earnings figure
Valuation based on current earnings is equal to current earnings divided by the company’s current cost of capital.
V = E/k
E = Earnings.
k = The cost of capital.
Apart from estimating the cost of equity capital, earnings-based valuation relies on some accounting judgments to confirm the integrity of current earnings.
The exercise may call for adjustments in the reported figures to render the current earnings figure the best estimate of the company’s sustainable long-term cash flows.
Distortion caused by one-time charges
Among justifications for adjusting current earnings is the distortion caused by one-time charges. Companies sometimes bury bad news affecting multiple years into a single charge and dismiss the result as a nonrecurring episode. Adjusting for this practice requires reallocating the one-time charge across multiple periods and adjusting the current year’s earnings accordingly.
Distortion caused by noncash charges
Other justifications for adjusting current earnings are accounting allocations for noncash charges such as depreciation and amortization. These are intended to serve as a proxy for how close a company’s capital assets are drawing to the ends of their useful lives and must be replaced. It is common for the required reinvestment in such capital assets to exceed the amount allocated in the accounting.
Distortion caused by aberrant current year earnings
Current earnings may also be adjusted to the extent that the current year is an aberration for substantive economic reasons. If the year is a cyclical down year for the company, an upward adjustment based on earnings of prior years is indicated; if at a boom in the corporate or industrial business cycle, the reverse would be true.
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