What it means
Reported earnings per share is net profit divided by the number of shares. It can be distorted by unusual items, such as the cost of closing a factory or a one-off gain from selling a building.
Normalisation removes these items to show what the business earns in an ordinary year. Dilution deals with the other distortion.
Many companies have options, warrants and convertible bonds that could become shares in the future. If these are exercised, the profit has to be shared among more shares, so the figure per share would fall.
Diluted normalised earnings per share therefore uses two changes at once. The numerator is normalised earnings after tax, and the denominator is the weighted average number of shares plus the extra shares that dilutive securities could create.
One common method for options is the treasury stock method, which assumes the money paid to exercise them is used to buy back shares at the average market price. Analysts use the measure for valuation, since price-to-earnings ratios look more sensible when based on lasting earnings.
It also helps compare companies with different one-off items and capital structures. Readers should be aware that there is no single official definition of normalised earnings, so each analyst makes their own adjustments.
The main risk is subjectivity. A management team may be tempted to label recurring costs as one-offs, which would make normalised earnings look better than reality.
Reading the reconciliation from reported to normalised figures, and checking whether the same type of charge appears every year, helps avoid being misled. It helps to read the measure alongside cash flow.
Profit that is repeatedly adjusted for one-off costs but never turns into cash is a warning sign worth investigating. Consistent adjustments from year to year, with a clear explanation, are a better indicator of a trustworthy number.
In practice
Real-world examples.
Example
An analyst values a retailer that took a large charge for closing stores. She adds the charge back, calculates diluted normalised EPS of $2.40 against reported diluted EPS of $1.90, and bases her price target on the higher figure.
Example
A technology company has many employee share options outstanding. Its finance team shows investors both basic and diluted normalised EPS, so they can see how future share issues would reduce the profit attributable to each share.
Example
A private equity buyer examines a target with a large insurance gain in the latest year. The buyer removes the gain to see the true earnings per share before deciding on an offer price.
Formula
Calculation
Diluted normalised EPS = Normalised net income / Diluted weighted average shares
Suppose a company reports net income of $9,000,000. It includes a restructuring charge of $1,200,000 after tax and a one-off gain of $200,000 after tax. Normalised net income = 9,000,000 + 1,200,000 - 200,000 = $10,000,000. The company has 9,750,000 basic shares plus 250,000 extra shares from options under the treasury stock method, so diluted shares are 10,000,000. Diluted normalised EPS = 10,000,000 / 10,000,000 = $1.00, compared with diluted reported EPS of 9,000,000 / 10,000,000 = $0.90.Case study
Seen in the real world.
Halcyon Devices is an illustrative, fictional manufacturer that announced earnings per share of $0.80, down from $1.10 the year before. Investors were worried until the finance director published a reconciliation to diluted normalised earnings per share.
Reported net income was $8,000,000 on 10,000,000 shares. The reconciliation added back a $3,000,000 after-tax cost of a factory fire, removed a $500,000 gain on the sale of land, and added 500,000 shares for options. Normalised income was 8,000,000 + 3,000,000 - 500,000 = $10,500,000, so diluted normalised EPS was 10,500,000 / 10,500,000 = $1.00, a much smaller fall than the headline suggested.
The illustrative investors accepted that the underlying business was steady, and the share price recovered. The finance director also promised to use the same method each year, to keep the numbers credible.
Watch out
Common mistakes.
- Removing only the one-off costs and leaving the one-off gains in, which flatters the normalised figure.
- Ignoring dilution, so the profit per share looks higher than it would be if all options and convertibles were exercised.
- Treating normalised earnings as an official accounting number, when each company or analyst may define it differently.
Questions
People also ask.
Why is the diluted figure lower than the basic figure?
Because it assumes that options, warrants and convertibles are turned into shares, which spreads the same profit over more shares.
What counts as a one-off item?
Typical examples are restructuring costs, asset sale gains, legal settlements and impairments, but a cost that returns every year is probably part of normal trading.
Is it better to use reported or normalised EPS?
Each has a role, since reported EPS is what the accounts say, while normalised EPS helps estimate lasting performance.
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