When I consider potential investment decisions, one of the first things that I look at is a company's normalized earnings power. Instead of looking at the P/E ratio that you might find by looking at a stock screener, I try to identify the cases where a company has significant one-time or non-recurring events that are temporarily depressing earnings, and causing the long-term earnings power of a company to become understated. Of course, some companies get in the habit of posting a parade of non-recurring items that have the sneaky habit of appearing each year, so you still have to be discerning. Nevertheless, it can be a worthwhile endeavor to separate a company's current reported earnings from the normalized figures that represent the company's earnings base going forward.
If you look at a screenshot of Kellogg (NYSE:K), you will get the impression that the company is earning $2.52 while trading at a price of $65.90. At the surface level, it appears that Kellogg is trading at a P/E ratio of 26.05x earnings.
But once you adjust for one-time events, you will see that Kellogg has earned $3.37 in 2012, and this may signal the "base" of its earnings power. Once you adjust the figures, you will see that Kellogg is trading at a P/E ratio of 19.55. That may not be enough to initiate a buy (you would have to go back to 2001-2002 to find the last time that Kellogg traded at a P/E ratio that high), but it may be enough for an investor to consider Kellogg a "hold" and benefit from the 8% annual earnings growth that analysts expect for the maker of Keebler, Pop-Tarts, Pringles, and the eponymous Pringles brand.
Johnson & Johnson (NYSE:JNJ) is another example of a blue-chip stock that has normalized earnings power that is greater than what a typical stock screener might indicate. When you look up a quote of Johnson & Johnson stock, you may see that the company's share price of $87.64 is causing the company to trade at 23.85x earnings relative to earnings of $3.67.
But once you remove the one-time special events and non-recurring items, you can see that Johnson & Johnson has normalized earnings of $5.10. That changes the calculus considerably. Instead of 23.85x earnings, it seems that Johnson & Johnson is trading at 17.18x normalized earnings. This is about where the company traded at before the recall days (from 2003 to 2006, Johnson & Johnson typically traded in the range of 16.5x-19.5x earnings). This makes Johnson & Johnson appear much closer to the fair value range than earnings that the non-adjusted earnings might indicate.
Total SA (NYSE:TOT), the French oil giant, is another interesting company where the reported earnings understate the true earnings power of the firm. If you look at a stock screener, it may appear that the company is trading at 10.34x earnings, at a price of $50.11 relative to $4.84 in earnings.
What is interesting in this case is that Total SA posted normalized earnings of $7.01 in 2012, once you adjust for the one-time/non-recurring items. All of a sudden, we're looking at a P/E ratio of 7.14x earnings. During periods of stable commodities pricing, Total SA typically trades at 10.0x earnings (the rules change if the price of oil and natural gas are significantly in flux).
There are certain things in investing that catch my attention. When a company misses earnings estimates, yet still appears likely to grow profits, there may be an opportunity for investors. We saw this last month with IBM (NYSE:IBM). When a company is buying back shares at a rate that is faster than what is reflected in a stock screener (because most stock screeners report the discounted weighted average), I usually get interested. That's what led me to Dr. Pepper (NYSE:DPS) and McDonald's (NYSE:MCD). And lastly, I like to find companies that have long-term earnings power that is greater than what a quick look suggests. A lot of times, it can be useful to discount the non-recurring items and special events that are temporarily restricting earnings so that you can get a look at a company's "base" earnings power going forward.
Disclosure: I am long JNJ, DPS, IBM, MCD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.