Damodaran on Valuation

3.2. EARNINGS

The income statement for a firm provides measures of both the operating and equity income of the firm in the form of the earnings before interest and taxes (EBIT) and net income. When valuing firms, there are three important considerations in using these earnings. One is to obtain as updated an estimate as possible, given how much firms change over short periods. The second is to correct earnings for accounting misclassifi-cation. The third is that reported earnings at these firms may bear little resemblance to true earnings because of limitations in accounting rules and the firms' own actions.

3.2.1. Importance of Updating Earnings

Firms reveal their earnings in their financial statements and annual reports to stockholders. Annual reports are released only at the end of a firm's financial year, but we are often required to value firms all through the year. Consequently, the last annual report that is available for a firm being valued can contain information that is several months old. In the case of firms that are changing rapidly over time, it is dangerous to base value estimates on information that is this old. Instead, use more recent information. Since firms in the United States are required to file quarterly reports (10-Qs) with the Securities and Exchange Commission (SEC) and reveal these reports to the public, a more recent estimate of key items in the financial statements can be obtained by aggregating the numbers over the most recent four quarters. The ...