What are normalized earnings and when do I need them for equity valuation?

Question

AcadiFi · Accepted Answer

Normalized earnings represent what a company would earn in a 'normal' or mid-cycle environment, stripping out the effects of cyclical peaks and troughs. They are essential for valuing companies whose earnings fluctuate dramatically with economic conditions.

**Why Normalize?**

If you apply a P/E multiple to peak earnings, you overpay. If you apply it to trough earnings, you underpay. Normalized earnings solve this by estimating the sustainable mid-cycle earning power.

**Method 1: Historical Average EPS**

Simply average EPS over a full business cycle (typically 7-10 years).

Example — Ridgemont Steel Corp (fictional):

| Year | EPS |
|---|---|
| 2019 | $3.20 |
| 2020 | $0.80 (recession) |
| 2021 | $2.10 |
| 2022 | $5.40 (boom) |
| 2023 | $6.10 (boom) |
| 2024 | $4.50 |
| 2025 | $2.90 |

Normalized EPS = ($3.20 + $0.80 + $2.10 + $5.40 + $6.10 + $4.50 + $2.90) / 7 = **$3.57**

Current EPS (2025) = $2.90 — below normal, suggesting the stock may be undervalued if priced off trough earnings.

**Method 2: Average ROE x Current Book Value**

Average the ROE over the cycle and apply it to today's book value.

| Year | ROE |
|---|---|
| 2019-2025 average ROE | 14.2% |
| Current book value per share | $28.00 |

Normalized EPS = 14.2% x $28.00 = **$3.98**

This method captures the growth in the company's asset base over time, which Method 1 ignores.

```mermaid
graph TD
    A{"Normalizing Earnings"}
    A -->|"Method 1"| B["Average Historical EPS
Over Full Cycle"]
    A -->|"Method 2"| C["Average ROE x
Current Book Value"]
    B --> D["Simple
Ignores Growth"]
    C --> E["Captures Growth
Needs Reliable BV"]
    style B fill:#3b82f6,color:#fff
    style C fill:#c9a84c,color:#000
```

**When to Use Each:**

| Situation | Preferred Method | Reason |
|---|---|---|
| Stable, no-growth cyclical | Method 1 (avg EPS) | No significant asset base change |
| Growing cyclical company | Method 2 (avg ROE x BV) | Captures expanded earning power |
| Highly acquisitive company | Method 2 with caution | BV may include goodwill distortions |
| Negative book value | Method 1 | Method 2 breaks down |

**Applying Normalized Earnings to Valuation:**

Once you have normalized EPS, apply a mid-cycle P/E multiple (not the current multiple, which may be inflated by depressed earnings).

Example: If Ridgemont Steel's mid-cycle P/E is 12x:
- Value = 12 x $3.57 = $42.84 (Method 1)
- Value = 12 x $3.98 = $47.76 (Method 2)

Current price: $35.00 → stock appears **undervalued** on both methods.

**Common Pitfalls:**
- Using too short a window that doesn't capture a full cycle
- Ignoring structural changes (if the industry has permanently shifted, historical averages are misleading)
- Applying peak multiples to normalized earnings (double-counting the optimism)

**Exam tip:** When a CFA Level II vignette gives you 7+ years of EPS data for a cyclical company and asks for intrinsic value, it is almost certainly testing normalized earnings. Calculate using both methods if data permits.

Build your cyclical valuation skills in our CFA Level II equity section.

What are normalized earnings and when do I need them for equity valuation?

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