When calculating a company's earning-power, it is best to leave one-time events out of the equation. These events are not expected to repeat in the future, and doing so will give you a better idea of the earning power of the company.
If you are attempting to measure how profitable a business has been over a longer period, say five or ten years, you should average in the one-time events to paint a more accurate picture. For example, if a company purchased a building for $1 million in 1990, and sold it for $10 million ten years later in 2000, it is improper to consider the company earned $9 million in profit in the year 2000. Instead, the extraordinary income, in this case, $9 million, should be divided by the number of years it accrued (10 years - 1990 to 2000). Thus, $9 million in extraordinary income divided by 10 years = $900,000 in real estate profits per year.
Although the income statement will reflect a $9 million one-time profit for the business, the investor should restate the earnings during their analysis by going back and adding $900,000 to each of the years between 1990 and 2000. This will increase the accuracy of a trend line. Since the asset was quietly appreciating during this time, it should be reflected.
However, going forward, when attempting to value the business, you shouldn't include that $900,000 extra income per year because it won't be there in the future. That is why you cannot rely solely on past financial statements to figure out what you should pay for a business or stock. You have to be intelligent and use your understanding of what is really going on with a company.
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This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.
