Normalization of earnings is done for prior years to understand the cash flows generated by the core business in a normal year. Every year brings surprises. If these surprises are random one-off events that are not likely to occur, it is considered abnormal and removed to reflect what the earnings may have been in a normal year. Normalization is done to help you estimate future operating cash flows to use in a DCF valuation.
Earnings that reflect a typical year is considered “normalized” earnings. Every year brings surprises. If these surprises are random one-off events that are not likely to occur, it is considered abnormal and removed to reflect the earnings in a normal year.
Events considered abnormal and removed to normalize earnings may be positive (income) or negative (expenses) events.
Examples of events that need normalization:. Examples of expenses that are adjusted in normalizing earnings include litigation fees, unusual discretionary expenses, one of penalties and fines. Examples of income that are adjusted in normalizing earnings include awards received, unusual and one of projects, etc.
In preparing a DCF valuation, you often use the current EBIT as a base to arrive at future cash flows. However, EBIT includes all income and expenses that the company has encountered. This includes items that are regular and recurring and those that are irregular and may not occur. When we are valuing a company, we only what to know what the cash flows are likely to be in the future. Only cash flows that we can expect to occur again from today onward provide us value. Therefore, the EBIT must reflect only items that you will expect in the future.
The portion of R&D spend that is capitalized is usually only a small part of R&D. However, most companies benefit from R&D spending in the form of acquired know-how. This acquired know-how is a valuable asset that produces cash flow in the future. Analysts and investors should want the value of R&D spending in the balance sheet. So R&D should be treated like another investment and the R&D spending capitalized like other assets such as an investment in a building. But how do you capitalize R&D expenses? What are the steps involved in capitalizing R&D expenses?
This article discusses the steps involved in capitalizing R&D expenses.