What are some of the challenges issues and remedies associat

What are some of the challenges, issues and *remedies* associated with valuing firms with negative, low or otherwise abnormal earnings

Solution

Answer:

Analysts face many problems while valuing firms that are losing money or earnings negative returm. Most of these problems are significant from a measurement standpoint and as follow:

a) Earnings Growth Rate:

One cannot estimate the earnings growth rate of firm with negative return or can’t apply the same to current earnings to estimate future earnings.

For example, assume that there is a firm, whose operating earnings have gone from -$ 1000 million last year to - $ 500 million in the current year. Calculating growth rate:

= (Earnings Current Year / Earnings Last Year) – 1

= (-500 / -1000) – 1 = -50%

This clearly does not make sense since this firm has improved its earnings over the period.

b) Tax Calculations:

After tax earnings are calculated as follow

= Pre-tax operating income (1 – Tax Rate)

But the firm which is losing money or earning negative return usually can carry forward the losses and apply them to earnings in the future period. Thus, analysts valuing firms with negative earnings have to keep track of the net operating losses of these firms and remember to use them to shield income in future periods from taxes.

c) The Going Concern Assumption:

The final problem associated with valuing companies that have negative earnings is the very real possibility that these firms will go bankrupt if earnings stay negative. Therefore, the assumption of infinite live that underlies the estimation of terminal value may not apply in this case.