Normalizing Earnings for PE ratios

Normalizing Earnings for PE ratios

The dependence of PE ratios on current earnings makes them particularly vulnerable to the year-to-year swings that often characterize reported earnings.

In making comparisons, therefore, it may make much more sense to use normalized earnings.

The process used to normalize earnings varies widely but the most common approach is a simple averaging of earnings across time.

For a cyclical firm, for instance, you would average the earnings per share across a cycle. In doing so, you should adjust for inflation.

If you do decide to normalize earnings for the firm you are valuing, consistency demands that you normalize it for the comparable firms in the sample as well.

http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf