Usual or Unusual?

As noted by Ben Graham, when analyzing a potential investment, it's important to incorporate several years worth of operating earnings. This is due to the fact that in any one year, various external or internal factors could lead to annual numbers that are not representative of future results.

In performing such an analysis, investors will note that many companies designate certain expenses as 'unusual'. Common types of 'unusual' expenses include Goodwill writedowns (i.e. the company purchased another company some years ago and now realizes it overpaid for that company) and restructuring costs.

For many companies, perhaps these are indeed unusual expenses and will not occur again. For other companies, however, 'unusual' expenses seem to be a perfectly normal part of business as usual.

Consider New Frontier Media (NOOF), producer and distributor of adult-themed video-on-demand programming. Excluding what the company deems as unusual expenses, the company has earned operating income of $87 million over the last 8 years, averaging to $11 million per year. In five of those eight years, however, the company recorded 'unusual' expenses. Incorporating these expenses, NOOF's average operating income over the last 8 years reduces to $8.5 million, a reduction in value of over 20%!

To avoid making valuation mistakes, it's important for investors to consider several years worth of earnings (preferably an entire business cycle) and to seriously consider unusual expenses to determine if they are relevant in determining the company's current earnings power.

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